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Chapter 4: Q.13 (page 134)

Retired persons often have much of their wealth placed in savings accounts and other interest-bearing investments and complain whenever interest rates are low. Do they have a valid complaint?

Short Answer

Expert verified

Low nominal rates may have a negative impact on the wealth of senior adults and retirees.

Step by step solution

01

Step 1. Introduction

The commitment of an asset to increase in value over time is referred to as investment. Investment necessitates the loss of a current item, such as time, money, or effort. The goal of investing in finance is to make a profit from the asset you've put money into.

02

Step 2. Explanation

While it may appear that their wealth is eroding as nominal interest rates decrease, their real return on savings accounts will be unaffected as long as projected inflation declines at the same rate as nominal interest rates. In actuality, however, projected inflation as measured by the cost of living for seniors and retirees is frequently substantially greater than typical inflation metrics.

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Most popular questions from this chapter

Assume you just deposited \(1,250 into a bank account. The current real interest rate is 1%, and the expected rate of inflation over the next year is 5%. What nominal interest rate should the bank charge you over the next year? How much money will you have at the end of one year? If you are saving to buy a motorbike that currently sells for \)1,300, will you have enough money to buy it?

Why would a government choose to issue a perpetuity, which requires payments forever, instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?

A lottery claims its grand prize is \(15 million, payable over five years at \)3,000,000 per year. If the first payment is made immediately, what is this grand prize really worth? Use an interest rate of 7%.

Suppose today you buy a coupon bond that you plan to sell one year later. Which part of the rate of return formula incorporates future changes into the bond鈥檚 price?

The U.S. Treasury issues some bonds as Treasury Inflation Indexed Securities, or TIIS, which are bonds adjusted for inflation; hence the yields can be roughly interpreted as real interest rates. Go to the St. Louis Federal Reserve FRED database, and find data on the following TIIS bonds and their nominal counterparts. Then answer the questions below.

  • 5-year U.S. Treasury (DGS5) and 5-year TIIS (DFII5)
  • 7-year U.S. Treasury (DGS7) and 7-year TIIS (DFII7)
  • 10-year U.S. Treasury (DGS10) and 10-year TIIS (DFII10)
  • 20-year U.S. Treasury (DGS20) and 20-year TIIS (DFII20)
  • 30-year U.S. Treasury (DGS30) and 30-year TIIS (DFII30)

a. Following the Great Recession of 2008鈥� 2009, the 5-, 7-, 10-, and even the 20-year TIIS yields became negative for a period of time. How is this possible?

b. Using the most recent data available, calculate the difference between the yields for each of the pairs of bonds (DGS5 鈥� DFII5, etc.) listed above. What does this difference represent?

c. Based on your answer to part (b), are there significant variations among the differences in the bond-pair yields? Interpret the magnitude of the variation in differences among the pairs.
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