CH 11 - 2 Supply and demand

Question 1

1. General Concepts

Answer 1

Market Determinants: Prices are determined by the interaction of supply and demand.

Effect of Demand on Price:
* Increase in Demand → Price rises.
* Decrease in Demand → Price falls.

Effect of Supply on Price:
* Increase in Supply → Price falls.
* Decrease in Supply → Price rises.

Free Market Mechanism: Prices adjust so that supply equals demand.

Question 2

2. Demand Characteristics
3. Supply Characteristics

Answer 2

Demand Characteristics

Price Elasticity:
* Demand for most investments is highly price elastic due to the existence of close substitutes.
* Example: If the price of Investment A rises slightly above Investment B, investors will sell A and buy B.
* Result: Prices of similar securities remain close; identical securities will have identical prices (to avoid arbitrage opportunities).

Demand Changes:
* Small price changes → Large changes in quantity demanded.
* Demand changes faster and more dramatically than supply.

Supply Characteristics

Large changes in supply typically result in small effects on price.

Question 3

4. Factors Influencing Demand

Answer 3

Investor Expectations:
* Driven by expectations for the level and riskiness of returns.
* Influences include:
* Economic factors: Strongly impact real assets like equities and property.
* Inflation expectations: Affect the demand for financial instruments like bonds.

Example:
* Nominal returns on bonds are fixed, but real returns depend on inflation.
* High inflation expectations → Lower demand for bonds.

Question 4

Key Takeaways

Answer 4

• Changes in demand primarily drive price changes in investment markets.
• Real Assets: Returns depend on the economy’s state (e.g., equities, property).
• Financial Instruments: Returns influenced by economic factors like inflation.
• Market prices reflect the balance of supply and demand influenced by investor behavior and economic expectations.