1.Now consider a four-year bond with a face value of $5,000 and an annual coupon payment of $125. Suppose prevailing interest rates in the economy are 1.0%.

a.Calculate the predicted price of this bond. Did the price change by more or less than what you found in part a of the previous question?

b.Given your answer to part a, which would you rather hold if interest rates in the economy are expected to increase: long-term bonds or short-term bonds? Why?

2.We have seen that bond prices can be affected by changes in interest rates. Bond prices can also be affected by changes in inflation, which is the percentage changes in the overall price level of an economy. For example, if inflation is 2% per year, then it means that goods and services are becoming 2% more expensive over the year, on average.

a.Bond prices tend to decline with high inflation. Can you offer a reason for why this might happen? (HINT: Does a bond's coupon payment change over time or stay fixed?)

b.If bond prices tend to decline with higher inflation, how would bond yields react to higher inflation? What does this suggest about a relationship between interest rates in the economy and the inflation level of an economy?