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Chapter 17: Q10. (page 368)

Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?

Short Answer

Expert verified

If the Federal Reserve wants to reduce the stock prices, it should decrease the interest rates.

Step by step solution

01

Step 1. Explanation

As the expected rate of return increases, the demand for investments increases. With an increase in investment demand, the stock prices rise. Thus, an investment鈥檚 rate of return is directly related to its price.

To reduce the price of stocks, the rate of returns on stocks will have to be reduced. Controlling the risk premium is not in the hands of the Federal Reserve because it cannot alter the risk premium. However, the Fed can use its monetary policy to control the risk-free interest rate.

The Fed will increase the money supply in the economy, lowering the federal rates and other interest rates on the short-term government bonds. It will reduce the risk-free interest rate, and the expected rate of return will ultimately fall. Hence, the stock prices will cool down.

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Most popular questions from this chapter

Why is it so hard for actively managed funds to generate higher rates of return than passively managed index funds having similar levels of risk? Is there a simple way for an actively managed fund to increase its average expected rate of return?

Tammy can buy an asset this year for \(1,000. She is expecting to sell it next year for \)1,050. What is the asset鈥檚 anticipated percentage rate of return?

  1. 0 percent

  2. 5 percent

  3. 10 percent

  4. 15 percent

Suppose that a risk-free investment will make three future payments of \(100 in one year, \)100 in two years, and $100 in three years. If the Federal Reserve has set the risk-free interest rate at 8 percent, what is the proper current price of this investment? What is the price of this investment if the Federal Reserve raises the risk-free interest rate to 10 percent?

If we compare the betas of various investment opportunities, why do the assets that have higher betas also have higher average expected rates of return?

Consider an asset that costs \(120 today. You are going to hold it for 1 year and then sell it. Suppose that there is a 25 percent chance that it will be worth \)100 in a year, a 25 percent chance that it will be worth \(115 in a year, and a 50 percent chance that it will be worth \)140 in a year. What is its average expected rate of return? Next, figure out what the investment鈥檚 average expected rate of return would be if its current price were $130 today. Does the increase in the current price increase or decrease the asset鈥檚 average expected rate of return? At what price would the asset have a zero average expected rate of return?
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