Question

Consider tight money policy and its effects on stock prices via the simplified Gordon growth model equation.

Which of the following accurately describes the effects of tight money policy on stock​ prices, according to this​ model?
A. The retun on bonds, the required return on an equity investment (Kₑ), and the price of stock (P₀) would all al
B. The return on bonds and the requied return on an equity investment (kₑ) would fall, while the price of stock (Kₑ) would nse.
C. The return on bonds, the required return on an equity investment (Kₑ), and the price or stock (P₀) would all rise
D. The return on bonds and the required return on an equity investment (Kₑ) would rise while the price of stock (P₀) would fall

Answer 1

Under a tight money policy, increased interest rates lead to a higher return on bonds and a higher required return on equity (Ke), resulting in a lower price of stock (P0) according to the Gordon growth model.

Step-by-step explanation:

According to the simplified Gordon growth model, the effects of a tight money policy on stock prices can be understood through the change in the required return on an equity investment (Ke) and the price of stock (P0). A tight money policy tends to increase interest rates, which leads to a higher return on bonds. As higher interest rates make bonds more attractive, the required return on equity (Ke), which is the discount rate used in the Gordon growth model, would also rise to reflect the increased opportunity cost of investing in stocks compared to bonds.

Consequently, an increase in the required return on equity (Ke) would, all else being equal, decrease the price of stock (P0) because the higher discount rate reduces the present value of future dividends. Therefore, the correct answer would be: D. The return on bonds and the required return on an equity investment (Ke) would rise while the price of stock (P0) would fall.