Chapter 5: The Behavior of Interest Rates Flashcards
What determines the demand of an asset?
When you want to buy or hold an asset or want to determine whether you buy one asset rather than another one, you consider:
- Your wealth (1.1)
- The expected return (1.2)
- The risk (1.3)
- The liquidity (1.4)
Wealth
• The total resources owned by the individual, including all assets
Holding everything else constant, an increase in the wealth
raises the quantity demanded of an asset
Expected Return
• The return expected over the next period on the asset relative to alternative assets
If the expected return of the stock rises relative to the expected return of other assets, holding everything else constant, it becomes more interesting to invest in the stock, so the quantity demanded increases.
• This can happen when:
• The expected return of the stock rises while the expected return on other
assets remains the same
• The expected return of the alternative investments drop, and the expected
return on the stock remains unchanged
Risk
• The degree of uncertainty associated with the return on one asset relative to alternative assets
Holding everything else constant, if an asset’s risk rises relative
to that of alternative assets, its quantity demanded will fall
2 kinds people who risk
- Risk-averse people will prefer the sure investment
* Risk lovers or risk preferers will prefer to take risk
Liquidity
• The ease and speed with which an asset can be turned into cash relative to alternative assets
An asset is liquid if the market in which it is traded has depth and breadth, i.e. if it has many buyers and sellers.
The 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 Portfolio Choice
Holding all other factors constant:
1. 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
Bond Market
• Negative relationship between the interest rate and the price of the bond so if the interest rate increases, the price of the bond will drop
Market equilibrium
when the amount of bonds people are willing to
buy (demand) equals the amount people are willing to sell (supply) at a given price: at equilibrium interest
Shifts in the Demand for Bonds
- Wealth +
- Expected returns -
- Expected inflation -
- Risk -
- Liquidity +
Shifts in the Supply of Bonds
- Expected Profitability of Investment Opportunities: +
- Expected Inflation: +
- Government Activities: +
Fisher Effect
When expected inflation rises, nominal interest rates will rise:
- If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls.
- The rise in expected inflation also means that the real cost of
borrowing has declined, causing the quantity of bonds supplied to increase. - When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls.
- Since the bond price is negatively related to the interest rate, this means that the interest rate will rise.
Business Cycle Expansion
the amount of goods and services for the country is
increasing, so national income is increasing
The Liquidity Preference Framework
- An alternative model for determining the equilibrium interest rate (John Maynard Keynes)
- In terms of the supply and demand for money rather than in terms of the demand for bonds
