Paper 2 September 2011 Question 4

[Frances]

Hi,

There is a 3 mark question on why the bond yields on the government bonds may vary. In the solutions, it notes that there may be different risk free yields in the two economies, and that there may be lower risk-free rates in the domestic economy. Is this a typo - I had it the other way round i.e. in the major overseas economy.

Also, please could someone explain the point around how a devaluation of the domestic currency can lead to higher yields? And also why a devaluation would happen due to high levels of inflation.

Thanks,

Fran

 

[Lindsay Smitherman]

Hi Fran

Yes - you are right, this looks like a typo and it should be the other way around - good spot!

The point about devaluation and higher yields is that if it looks like the domestic currency is going to depreciate in value (for whatever reason), the domestic government may have to offer higher yields on its bonds in order to attract foreign investors. This is to compensate them for the fall in the value of their investment when expressed in terms of their own currency, as a result of the domestic currency devaluation.

If there are high levels of inflation in the domestic economy, this will mean that consumers would be more likely to buy goods that are produced in other countries, since these will have lower cost. Hence demand for domestic goods falls and demand from those living in the country for overseas goods increases - so the domestic currency is likely to depreciate in value relative to other currencies.

Hope that makes sense.

 

[Frances]

Thanks Lindsay - that makes sense now!