Based on Problem 16-1, imagine that initially the market interest rate is 5 percent and at this interest rate you have decided to hold half of your financial wealth as bonds and half as holdings of non-interest-bearing money. You notice that the market interest rate is starting to rise, however, and you become convinced that it will ultimately rise to 10 percent.
a. In what direction do you expect the value of your bond holdings to go when the interest rate rises?
b. If you wish to prevent the value of your financial wealth from declining in the future, how should you adjust the way you split your wealth between bonds and money? What does this imply about the demand for money?