1. remained the same but its real value declined.
2. declined along with its real value.
3. declined but its real value remained the same.
4. and its real value remained unchanged because neither the rate of interest nor the permanent rate of inflation changed.
Choose the correct option.
Option 1 is correct. The rate interest is the same before and after the unexpected rise in the price level. Since the coupon yield of the bond also does not change, its present value and market price will remain unchanged. The unexpected rise in the price level, however, will have reduced the real value of the both the coupon yield and the bond itself by about (100)(140 - 120)/120 = 16.667 percent.
Note that it is extremely important here that the rise in the price level be unanticipated. As we will show in the topic to be studied next, changes in the expected rate of inflation will have an effect on the interest rate and the market price of the asset.