chapter 11: the behavior of interest rates Flashcards
asset
a piece of property that is a store of value
what must one consider when choosing whether to hold an asset or not?
wealth
expected return
risk
liquidity
wealth
the total resources owned by the individual, including all assets
expected return
the return expected over the next period
risk
the degree of uncertainty associated with the return
liquidity
the ease and speed with which an asset can be turned into cash
holding everything else constant, how does an increase in wealth affect the quantity demanded of an asset?
increases quantity demanded of an asset
how does an increase in an asset’s expected return relative to that of an alternative asset affect quantity demanded of former?
raises the quantity demanded of the asset
since more people are risk averse, how does the rise in risk of an asset affect quantity demanded of the asset
Qd will fall
how does liquify affect quantity demanded of an asset?
he more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded
theory of asset demand
- The quantity demanded of an asset is positively related to wealth.
- The quantity demanded of an asset is positively related to its expected return relative to alternative assets.
- The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets.
- The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
a bond demand curve
which shows the relationship between the quantity demanded and the price
ceteris paribus
latin for other things being equal”
formula for bond expected return and interest
i = RET = (F - P) / P
I = interest rate = yield to maturity
RET = expected return
F = face value of the discount bond
P = initial purchase price of the discount bond
will higher interest rates increase or decrease the Qd of bonds? why?
Qd will increase the higher the interest rates
prices will be cheaper and cheaper
bond supply curve
shows the relation- ship between the quantity supplied and the price of bond
how do interest rates of a bond affect supply?
the lower the rate, the higher the price, the more the Qs
bond market equilibrium
when the quantity of bonds demanded equals the quantity of bonds supplied
excess supply of bonds
more bonds supplied than bonds demanded
will drive price down eventually to equilibrium
excess demand of bonds
more bonds demanded than bonds supplied
will drive price up eventually to equilibrium
The asset market approach for understanding behaviour in financial markets
emphasizes stocks of assets rather than flows in determining asset prices
the dominant methodology used by economists because correctly conducting analyses in terms of flows is very tricky, especially when we encounter inflation
factors that cause the demand curve for bonds to shift
- Wealth
- Expected returns on bonds relative to alternative assets
- Risk of bonds relative to alternative assets
- Liquidity of bonds relative to alternative assets
in a business cycle expansion with growing wealth, what happens to overall demand of bonds?
basically when economy is booming
the demand for bonds rises and the demand curve for bonds shifts to the righ
in a recession with decreasing wealth, what happens to overall demand of bonds?
basically when economy is trash
the demand for bonds falls, and the demand curve shifts to the left
how does an expectation that interest rates will rise affect the demand curve for bonds? why?
Higher expected interest rates in the future lower the expected return for long-term bonds
decrease the demand
shift the demand curve to the left
higher interest rates = decrease in price
how does an expectation that interest rates will fall affect the demand curve for bonds? why?
lower expected interest rates in the future increase the expected return for long-term bonds
increase the demand
shift the demand curve to the right
lower interest rates = increase in price
if people thought that stocks will bring more return than bonds in the future, how will it affect the bond demand curve? why?
the expected return on bonds today relative to stocks would fall
lowering the demand for bonds and shifting the demand curve to the left.
if people thought that stocks will bring less return than bonds in the future, how will it affect the bond demand curve? why?
the expected return on bonds today relative to stocks would rise
increasing the demand for bonds and shifting the demand curve to the right.
what does an increase in expected rate of inflation affect demand for bond?
lowers the expected return for bonds, causing their demand to decline and the demand curve to shift to the left
what does an decrease in expected rate of inflation affect demand for bond?
increases the expected return for bonds, causing their demand to increase and the demand curve to shift to the right
how does an increase in the risk of bonds affect the demand for bonds?
causes the demand for bonds to fall and the demand curve to shift to the left
how does a decrease in the risk of bonds affect the demand for bonds?
causes the demand for bonds to rise and the demand curve to shift to the right
how does an increase in the risk of other assets such as stocks affect the demand for bonds?
causes the demand for bonds to rise and the demand curve to shift to the right
how does a decrease in the risk of other assets such as stocks affect the demand for bonds?
causes the demand for bonds to decrease and the demand curve to shift to the left
how does an increase in liquidity of bonds affect the demand for bonds? why?
Increased liquidity of bonds results in an increased demand for bonds
the demand curve shifts to the right
it means more people are in the market and you can sell your bonds faster
how does a decrease in liquidity bonds affect the demand for bonds? why?
decreased liquidity of bonds results in an decrease demand for bonds
the demand curve shifts to the left
it means less people are in the market and you have more trouble selling your bond
how does an increase in liquidity of other assets affect the demand for bonds?
lowers the demand for bonds and shifts the demand curve to the left
how does a decrease in liquidity of other assets affect the demand for bonds?
increases the demand for bonds and shifts the demand curve to the right
Certain factors can cause the supply curve for bonds to shif
- Expected profitability of investment opportunities
- Expected inflation
- Government activities
how does a business cycle expansion (booming economy) affect the bond supply? why?
the supply of bonds increases
the supply curve shifts to the right
companies expect to make more money but they still need capital, so they can borrow more, hence selling more bonds
how does a recessions affect the bond supply? why?
the supply of bonds decrease
the supply curve shifts to the left
companies don’t expect to make more money so they don’t need capital
they are not willing to borrow, sense are not selling as many bonds
how does an increase in expected inflation affect supply? why?
causes the supply of bonds to increase
the supply curve to shift to the right
when expected inflation increases, the real cost of borrowing falls
corporations and government need to borrow more
how does an increase in expected deflation affect supply?
causes the supply of bonds to decrease
the supply curve to shift to the increase
how do higher government deficits affect the supply of bonds? why?
increase the supply of bonds
shift the supply curve to the right
he government sells more bonds to get money to finance these deficits
how do higher government surpluses affect the supply of bonds?
decrease the supply of bonds and shift the supply curve to the left
how does expected a rise in expected inflation affect interests? why?
interest rates will rise
there is more supply of bonds and less demand
supply of bonds shifts to right and demand shifts to right
new equilibrium price is lower
a lower price = higher interest rates
how will a decrease in inflation affect interests?
interest rates will decrease as well
how will a booming economy impact interest rates? why?
interest can either rise or fall, it will depend on which of the supply and demand curve shifts the most
both of the curves shift to the right in this case
are low interests always a good thing? give an example with asian country
no it is not always a good thing
it may seem like its cheaper to borrow as a corporation, but it usually means that you economy is in trouble
Japan got negative interest rates for the first time and they were low-key screwed
how does a decrease in wealth (as a consumer) affect bond interest rates?
interest rates rise
since the demand for bonds decrease, the curve shifts to the left
the equilibrium will be lower which means bond prices are lower which means interests rate
liquidity preference (John Maynard Keynes)
alternative model for determining the equilibrium interest rate
determines the equilibrium interest rate in terms of the supply of and demand for money
The starting point of Keynes’s analysis
there are two main categories of assets that people use to store their wealth: money and bonds
total wealth in the economy must equal the total quantity of bonds plus money in the economy
equals the quantity of bonds supplied Bs plus the quantity of money supplied Ms
The quantity of bonds Bd and money Md that people want to hold and thus demand must also equal the total amount of wealth, because people cannot purchase more assets than their available resources allow
liquidity preference (John Maynard Keynes’) formula
the quantity of bonds and money supplied must equal the quantity of bonds and money demanded
Bs + Ms = Bd + Md
Bs - Bd = Md - Ms
Keynes’ definition of money includes what?
currency (which earns no interest)
chequing account deposits (which in his time typically earned little or no interest),
he assumed that money has a zero rate of return
the demand for money is positively or negatively related to interest rates? why?
negatively related
the opportunity cost of not holding a bond in favor of money
how does a rise in interest rate affect the demand for money?
the opportunity cost of holding money increases
money becomes less desirable and the quantity of money demanded must fall
how does a decrease in interest rate affect the demand for money?
the opportunity cost of holding money decrease
money becomes more desirable and the quantity of money demanded must rise
explain how a market will a surplus of money supplied
The excess supply of money means that people are holding more money than they desire
they will try to get rid of their excess money balances by trying to buy bonds
they will bid up the price of bonds, and as the bond price rises, the interest rate will fall toward the equilibrium interest rate
explain how a market will a deficit of money supplied
basically more money demanded than money supplied
excess demand for money because people want to hold more money than they currently have
To try to obtain more money, they will sell their only other asset (bonds) and the price will fall
As the price of bonds falls, the interest rate will rise toward the equilibrium rate
In Keynes’ liquidity preference analysis, which two factors cause the demand curve for money to shift?
income and the price level
how does a higher income (income effect) affect the demand for money? why?
causes the demand for money at each interest rate to increase and the demand curve to shift to the right
people will want to hold more money as a store of value whenever there is an economic boom and overall income increases
as the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money
what does a rise in prices do to the demand for money? why?
causes the demand for money at each interest rate to increase and the demand curve to shift to the right
people want to buy what they used to buy now at higher prices
how does a rise in income in a booming economy affect interest rates? why?
Keynes’ logic
interest rates will rise
demand for money is shifted to the right which means that new equilibrium is now higher than previous equilibrium
people do not want bonds, which means they well sell them, which lowers their price, which make interests rise
how does a decrease in income in a recession affect interest rates? why?
Keynes’ logic
interest rates will decrease
demand for money is shifted to the left which means that new equilibrium is now lower than previous equilibrium
people want bonds instead of money, which means they well buy them, which increases their price, which make interests decrease
how does a rise in prices in a booming economy affect interest rates? why?
Keynes’ logic
interest rates will rise
people have increased their demand for money
they will sell bonds to get that money which will decrease their price
how does an increase in supply of money affect interest rates? is this ways true?
interest rates will decline
the new equilibrium will be lower than the `previous one
not this is not always true
the income effect of an increased supply of money on interest rates
why is it like this?
the income effect of an increase in the money supply is a rise in interest rates
it is response to the higher level of income that people now have
higher income means higher demand for money which means less bonds which means higher interest rates
the price level effect of an increased supply of money on interest rates
why is it like this?
a rise in interest rates in response to the rise in the price level
higher prices means higher demand for money which means less bonds which means higher interest rates
expected inflation effect of an increased supply of money on interest rates
why is it like this?
is a rise in interest rates in response to the rise in the expected inflation rate
in response to price being higher as well
higher prices means higher demand for money which means less bonds which means higher interest rates
difference between price level effect and expected inflation effect
the price-level effect remains even after prices have stopped rising, whereas the expected-inflation effect disappears
the expected-inflation effect will persist only as long as the price level continues to rise
However, when the price level stops rising next year, inflation and the expected inflation rate will return to zero. Any rise in interest rates as a result of the earlier rise in expected inflation will then be reversed
so what is the verdict with the increase of supply of money? how does it affect interest rates?
he rising money supply leads to an immediate decline in the equilibrium interest rate
The income and price-level effects take time to work because it takes time for the increasing money supply to raise the price level and income, which in turn raise interest rates
The expected-inflation effect, which also raises interest rates, can be slow or fast, depending on whether people adjust their expec- tations of inflation slowly or quickly when the money growth rate is increased.
how does a bigger liquidity effect affect the interest rate after supplying more money?
the bigger the liquidity effect, the less chances that the interest rate will return to the original state after the income, price level, and expected inflation effects take place
what happens if the expected inflation effect takes over after pumping money?
interest immediately rise
government takes a L
how does a liquidity effect smaller than the income, price level, and expected inflation effects affect the interest rate after supplying more money?
at first interest will lower, but then after it will be even higher than the original level
