Question

Suppose the cross-price clasticity of demand between stocks and bonds is \(-1.2\). If stock prices are expected to rise by 10 percent, what is expected to happen to bond prices? Does this make sense? Explain.

Short answer

Answer: The expected percentage change in bond prices is -12%. This result makes sense because bonds and stocks are complementary goods, so when stock prices are expected to rise, investors may shift their investments from bonds to stocks, leading to a decrease in bond prices.

Step-by-step solution

Understand the Cross-Price Elasticity Formula

The formula for cross-price elasticity is given by: Cross-price elasticity = (Percentage Change in Quantity Demanded of Good 1) / (Percentage Change in Price of Good 2) In this case, the cross-price elasticity of demand between stocks and bonds is -1.2.

Calculate the Expected Percentage Change in Bond Prices

Let's denote the percentage change in bond prices as x. We know the cross-price elasticity and the percentage change in stock prices, so we can set up the equation and solve for x: -1.2 = (x) / (10%) x = -1.2 * 10% x = -12%

Interpret the Results

The expected percentage change in bond prices is -12%. This means that if stock prices are expected to rise by 10%, bond prices are expected to decrease by 12%.

Explain the Relationship

This result makes sense because bonds and stocks are complementary goods, as indicated by the negative cross-price elasticity. Investors tend to invest in bonds when they believe that stocks are too risky or overvalued, and vice versa. So, when stock prices are expected to rise, investors may shift their investments from bonds to stocks, leading to a decrease in bond prices.