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.

Key concepts

Stocks and Bonds Relationship

In the world of finance, understanding the relationship between stocks and bonds is crucial for making informed investment decisions. Stocks represent ownership in a company, while bonds are essentially loans made to the government or corporations. Though both are investment vehicles, they react differently to market dynamics due to their inherent nature.

When stock prices rise, it often reflects a bullish market, where investors are optimistic about the economy and business prospects. In contrast, bonds are generally considered safer investments. They are more appealing in less volatile markets or when there's an economic downturn.

However, the relationship between stocks and bonds is not always straightforward. As seen in the cross-price elasticity of demand, a negative relationship suggests that as stock prices increase, bond prices tend to decrease. This happens because investors may pull their funds out of bonds due to the anticipated higher returns from stocks. It's like a see-saw; when one goes up, the other often goes down. Understanding this can help investors balance their portfolios by knowing when to shift between stocks and bonds based on market trends.

Investment Decisions

Investment decisions are critical in determining an investor's financial success. These decisions are influenced by one's risk tolerance, expected returns, and market dynamics. With numerous options available, choosing between stocks and bonds is a common dilemma for many investors.

Each type of investment has its characteristics. Stocks tend to offer higher returns with higher risk, while bonds provide lower risk with more stable returns. So, investors must consider factors such as market conditions, interest rates, and their personal financial goals.

For instance, in an environment where stock prices are rising, some investors may opt to invest in stocks, expecting higher returns. However, others may prefer the stability and lower risk associated with bonds, especially if they are risk-averse. The decision to switch allocation between stocks and bonds can be influenced by the historical and expected performance of these assets, as indicated by measures like cross-price elasticity.

Complementary Goods in Economics

In economics, complementary goods are products that are often used together. The relationship between such goods is crucial when analyzing market behavior. When the price of one good changes, it can affect the demand for the other.

In our example with stocks and bonds, they exhibit characteristics of complementary goods in that their demand is influenced by their relative attractiveness to each other. The cross-price elasticity of demand provides insight into this relationship.

A negative cross-price elasticity, such as -1.2 between stocks and bonds, indicates that they are weak complements. When the price of stocks increases, the demand for bonds decreases, causing bond prices to fall. This relationship helps explain why investors might move their investments between stocks and bonds based on changing prices.

Understanding complementary goods and their economic principle can help investors predict market movements and make strategic investment decisions that maximize their returns.