Chapter 5 Flashcards
Determinates of Asset Demand (including Bonds)
Wealth
Expected Return
Risk
Liquidity
the total resources owned by an individual, including all assets
*If wealth increases, asset demand increases (positive relationship).
*During a business cycle expansion, income and wealth rise so demand increases.
*During a recession, income and wealth fall so demand decreases.
Wealth
the return expected, over the next period, on one asset relative to
alternative assets
*If the expected return increases, asset demand increases (positive relationship)
A decrease in expected returns on other assets causes an increase in the
demand for bonds
.An increase in expected inflation causes a decrease in the expected return (real
interest rate) on bonds so the demand for bonds decreases.
Expected Return
the degree of uncertainty associated with the return on one asset relative
to alternative assets
*If risk increases, asset demand decreases (negative relationship).
*More volatile prices in the bond market causes bonds to become riskier so the demand
for bonds decreases.
*When other assets become riskier compared to bonds, the demand for bonds increases.
Risk
the ease and speed with which an asset can be turned into cash relative
to alternative assets
*If liquidity increases, asset demand increases (positive relationship).
*If people become more interested in owning bonds, they become more liquid so
the demand for bonds increases.
*When it becomes easier or less expensive to sell other assets, those assets
become more liquid compared to bonds and the demand for bonds decreases.
Liquidity
Recall that bonds are issued by businesses and government to finance their activities.
1. Expected Profitability of Investment Opportunities - the expected profit from investment in plant and equipment
* If the expected profitability increases, bond supply increases (positive relationship).
* During a business cycle expansion, profitable investment opportunities increase so the supply of bonds increases.
2. Expected Inflation - real interest rate equals the nominal interest rate minus the expected inflation rate
* If expected inflation increases, real cost of borrowing decreases so supply of bonds increases.
3. Government Budget Deficits - U.S. Treasury securities are used to finance government spending when it exceeds tax revenues
* When government deficits rise, the supply of bonds increases.
* Government surpluses result in a decrease in the supply of bonds.
Determinants of a Bond Supply
The unique point where the quantity that entities want to sell equals the quantity people want to buy OR where supply of bonds= demand for bonds
Market Equilibrium
1) Expected return (real interest rate) on bonds decreases so demand for bonds decreases; Bd1 shifts left to Bd2
2) Real cost of borrowing decreases so supply of bonds increases; Bs1 shifts right to Bs2
3) The result: Prices of bonds falls and interest rate rises
If expected inflation rate increases:
Uses the money market to determine the equilibrium interest rate which occurs where M^s=M^d
Developed by John Maynard Keynes
He said wealth can be held in two primary forms:
Money (does not earn interest)
An interest-bearing asset such as a bond
Total wealth= money + bonds
Opportunity cost (or tradeoff) of holding money is the interest rate that is given up by not holding bonds
As interest rate rises, people want to hold more bonds and less money; money demand and interest rate are negatively (or inversely) related
Assume the central bank (fed reserve) controls the M^s so it is fixed (vertical) at a given quantity
Remember: economic forces push a market toward equilibrium
Liquidity Preference Framework
An increase in incomes (business cycle expansion), people hold more money (to spend and save) so M^d1 increases to M^d2 and equilibrium i(interest) rises.
Income Effect
An increase in the price level means the cost of everything rises and more money is needed to purchase the same amount of goods and services so M^d1 increases to M^d2 and equilibrium i(interest) rises.
Price-level Effect
If the Federal Reserve increases the supply of money (expansionary monetary policy), M^S1 increases to M^S2 and equilibrium i (interest) falls.
Shifts in the Supply of Money
agreed with the liquidity preference framework thta and increase in M^s will lower equilibrium i, and he called this the liquidity effect, But he also said the increase in the M^s can cause othero changes in the economy that will raise equilibrium i.
Income Effect: An increase in the M^s can cause income and wealth to rise which causes M^d to increase and equilibrium i rises.
Price-Level Effect: An increase in the M^s can cause the price level to rise which causes M^d to increase and equilibrium i rises.
Milton Friedman
