PROBLEM SET 3 - EXPECTATIONS, PRESENT VALUES - QUESTIONS

ANSWERS

1. Suppose your parents offer you two different ways in which you can have your inheritance.

Suppose that the interest rate is 5%, what is the expected lifetime for your parents after which you to take Method 2 (based solely on present values.)

2. Suppose that you win the lottery and will receive $100,000 now, another 100,000 a year from now and a final 100,000 two years from now. Calculate the present discounted value of these payments when the interest rate is expected to be:

3. Using the IS-LM model determine the impact on C, I, Y, r (real interest rate), and i (nominal interest rate) of a decrease in the expected inflation rate.

4. Suppose that it suddenly became possible for anyone to borrow money from a bank using his or her expected future earnings to guarantee the loan. What impact do you think this change would have on the current level of consumption? What impact do you think this change would have on the marginal propensity to consume?

5. A pretzel manufacturer is considering buying another pretzel-making machine that costs $50,000. The machine will depreciate by 10% per year. It will generate real profits equal to $10,000 this year, $10,000(1-10%) next year (that is the same real profits, but adjusted for depreciation), $10,000(1-10%)2 the two years from now, and so on. Determine whether the manufacturer should buy the machine if the real interest rate is assumed to remain constant at:

6. An investor can sell a bottle of wine today for $7,000 or put it in storage and sell it in 30 years for a real $20,000. If the real interest rate is expected to remain constant at 4%, what should the investor do?

7. Determine the yield to maturity of each of the following bonds.

a. A discount bond with a face value of $1,000, a maturity of two years and a price of $800.
b. A discount bond with a face value of $1,000, a maturity of two years and a price of $900. 8. Suppose that the interest rate this year is 4% and financial markets expect interest rates to increase by 1% each year thereafter. Determine the yield to maturity on a: 9. A share is expected to pay a real dividend of $100 next year, and thereafter the real value of dividend payments is expected to increase by 3% per year, forever. Determine the current price of the stock if the real interest rate is expected to remain constant at: 10. A new president - who promised during the campaign that she would decrease future income taxes has just been elected. Assume that the people trust that the new president will keep her promise. Using the IS-LM model with only two periods (current and future) and zero expected current and future inflation, determine the impact on current output, the current interest rate, and current private spending under each of the following assumptions: 11. An economist is asked to testify in court about the present value of lost wage income for an individual who was injured in an accident. The data show that the individual had a wage income of $20,000 per year and was 55 years old. There is no controversy concerning the fact that the individual is permanently injured and will be unable to work. Under the assumption that the individual's income would stop at after 10 years, the economist testified in court that the present value of lost income is $200,000. The lawyer for the defense gets up and says, "How did you get $200,000? That is just the sum over 10 years of the lost income? What happened to inflation, what happened to the present value?" What is the economist's response?

12. Consider an increase in government spending. Such an increase could be financed by (1) an increase in taxes, (2) an increase in borrowing from the public, and (3) an increase in borrowing from the Federal Reserve. Explain how the effect on the stock market of an increase in government spending is related to the method used to finance the increased spending.

 ANSWERS