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Bonds typically promise to pay a sequence of fixed nominal payments. However, other types of bonds, called indexed bonds, promise payments adjusted for inflation rather than fixed nominal payments.
In words, the price of two-year bonds is the present value of the payment in two years—discounted using current and next year’s expected one-year interest rate.
The yield to maturity on an n-year bond, or the n-year interest rate, is the constant annual interest rate that makes the bond price today equal to the present value of future payments of the bond.
The yield to maturity on a two-year bond, is closely approximated by:
In words, the two-year interest rate is (approximately) the average of the current one-year interest rate and next year’s expected one-year interest rate.
Long-term interest rates reflect current and future expected short-term interest rates.
An upward sloping yield curve means that long-term interest rates are higher than short-term interest rates. Financial markets expect short-term rates to be higher in the future.
A downward sloping yield curve means that long-term interest rates are lower than short-term interest rates. Financial markets expect short-term rates to be lower in the future.
Using the following equation, you can fine out what financial markets expect the 1-year interest rate to be 1 year from now:
In November 2000, the U.S. economy was operating above the natural level of output. Forecasts were for a “soft landing,” a return of output to the natural level of output, and a small decrease in interest rates.
From November 2000 to June 2001, an adverse shift in spending, together with a monetary expansion, combined to lead to a decrease in the short-term interest rate.
From this figure, you can see the two major developments:
The adverse shift in spending was stronger than had been expected. Instead of shifting from IS to IS’ as forecast, the IS curve shifted by much more, to IS’’.
Realizing that the slowdown was stronger than it had anticipated, the Fed shifted in early 2001 to a policy of monetary expansion, leading to a downward shift in the LM curve.
They expected a pickup in spending-a shift of the IS curve to the right, from IS to IS’.
They also expected that, once the IS curve started shifting to the right and output started to recover, the Fed would start shifting back to a tighter monetary policy.
Through equity finance, through issues of stocks—or shares. Instead of paying predetermined amounts as bonds do, stocks pay dividends in an amount decided by the firm.
15-2 The Stock Market and Movementsin Stock Prices
15-2 The Stock Market and Movementsin Stock Prices
The price of a stock must equal the present value of future expected dividends, or the present value of the dividend next year, of two years from now, and so on:
15-2 The Stock Market and Movementsin Stock Prices
The Stock Market and Economic Activity
A monetary expansion decreases the interest rate and increases output. What it does to the stock market depends on whether financial markets anticipated the monetary expansion.
An Expansionary Monetary Policy and the Stock Market
An Increase in Consumer Spending and the Stock Market
15-2 The Stock Market and Movementsin Stock Prices
The Stock Market and Economic Activity
The increase in consumption spending leads to a higher interest rate and a higher level of output. What happens to the stock market depends on the slope of the LM curve and on the Fed’s behavior.
An Increase in Consumption Spending and the Stock Market
An Increase in Consumer Spending and the Stock Market
15-2 The Stock Market and Movementsin Stock Prices
The Stock Market and Economic Activity
If the LM curve is steep, the interest rate increases a lot, and output increases little. Stock prices go down. If the LM curve is flat, the interest rate increases little, and output increases a lot. Stock prices go up.
An Increase in Consumption Spending and the Stock Market
An Increase in Consumer Spending and the Stock Market
15-2 The Stock Market and Movementsin Stock Prices
The Stock Market and Economic Activity
If the Fed accommodates, the interest rate does not increase, but output does. Stock prices go up. If the Fed decides instead to keep output constant, the interest rate increases, but output does not. Stock prices go down.
An Increase in Consumption Spending and the Stock Market
There are several things the Fed may do after receiving news of strong economic activity:
They may accommodate, or increase the money supply in line with money demand so as to avoid an increase in the interest rate. An example of Fed accommodation is shown in Figure 15-8(c).
They may keep the same monetary policy, leaving the LM curve unchanged causing the economy to move along the LM curve.
Or the Fed may worry that an increase in output above YA may lead to an increase in inflation.
An Increase in Consumer Spending and the Stock Market
15-2 The Stock Market and Movementsin Stock Prices
Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday and Other Stories
Here are some quotes from the Wall Street Journal from April 1997 to August 2001. Try to make sense of them, using what you’ve just learned:
April 1997.Good news on the economy, leading to an increase in stock prices: “Bullish investors celebrated the release of market-friendly economic data by stampeding back into stock and bond markets, pushing the Dow Jones Industrial Average to its second-largest point gain ever and putting the blue-chip index within shooting distance of a record just weeks after it was reeling.”
December 1999.Good news on the economy, leading to a decrease in stock prices: “Good economic news was bad news for stocks and worse news for bonds. . . . The announcement of stronger-than-expected November retail-sales numbers wasn’t welcome. Economic strength creates inflation fears and sharpens the risk that the Federal Reserve will raise interest rates again.”
Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday and Other Stories
September 1998. Bad news on the economy, leading to an decrease in stock prices: “Nasdaq stocks plummeted as worries about the strength of the U.S. economy and the profitability of U.S. corporations prompted widespread selling.”
August 2001. Bad news on the economy, leading to an increase in stock prices: “Investors shrugged off more gloomy economic news, and focused instead on their hope that the worst is now over for both the economy and the stock market. The optimism translated into another 2% gain for the Nasdaq Composite Index.”
Famous Bubbles: From Tulipmania in Seventeenth-Century Holland to Russia in 1994
Tulipmania in HollandIn the seventeenth century, tulips became increasingly popular in western European gardens. A market developed in Holland for both rare and common forms of tulip bulbs.
The MMM Pyramid in RussiaIn 1994 a Russian “financier,” Sergei Mavrody, created a company called MMM and proceeded to sell shares, promising shareholders a rate of return of at least 3,000% per year!
The trouble was that the company was not involved in any type of production and held no assets, except for its 140 offices in Russia. The shares were intrinsically worthless. The company’s initial success was based on a standard pyramid scheme, with MMM using the funds from the sale of new shares to pay the promised returns on the old shares.
default risk maturity yield curve or term structure
of interest rates government bonds corporate bonds bond ratings risk premium junk bonds discount bonds face value coupon bonds coupon payments coupon rate current yield life (of a bond) Treasury bills (T-bills)
Treasury notes Treasury bonds indexed bonds expectations hypothesis arbitrage yield to maturity, or n-year
interest rate soft landing debt finance equity finance shares, or stocks dividends random walk Fed accommodation fundamental value rational speculative bubbles fads