Demand and Supply of Bonds Flashcards
What are the determinants of asset demand?
1) Wealth
2) Expected returns
3) Risk
4) Liquidity
What is the theory of portfolio choice?
Tells us how much of an asset people will want to hold in their portfolios:
- wealth – positive
- risk – negative
- liquidity – positive
- return – positive
What are the determinants of asset supply?
1) Expected profit of opportunities
2) Expected inflation
3) Government budget
What is the Fisher Effect?
When expected inflation rises, so does the interest rate.
How are prices of assets and interest rates related?
They have a negative relationship: when P increases, interest rate decreases.
How do interest rates change in the business cycle?
Expansion: interest rates increase.
Recession: interest rates decrease.
What is secular stagnation?
When firms decrease investment spending by supplying fewer bonds + interest rates decrease but investment does not increase.
Liquidity preference framework
Model that predicts the equilibrium interest rate on the basis of the supply of and demand for money.
What are the determinants of demand for money?
1) Income effect
2) Price-level effect
Income effect
A higher level of income causes the demand for money at each interest rate to increase.
Price-level effect
A rise in price level causes the demand for money at each interest rate to increase.
What are the determinants of supply of money?
Controlled by the central bank.
Movement along a curve
Quantity of bonds demanded/supplied changes due to 𝑃 changes.
Shift in a curve
Quantity of bonds demanded/supplied changes at every 𝑃 due to a change in
the factors affecting the demand and/or supply of bonds.
What are the assumptions of the liquidity preference framework?
1) Wealth can be stored in either M or B
2) Money has R = 0
3) Bonds have R = interest rate
What is the relationship between the money and bond market?
Excess supply in one market equals excess demand in the other market.
What is the relationship between the money and bond market?
Excess supply in one market equals excess demand in the other market.
What is the liquidity effect?
When the money supply increases, interest rates will decrease.
What is the income effect when Ms increases?
If Ms increases, Y increases, this means wealth increases; an increase in GDP causes interest rates to increase (Bd and Bs increase).
What are the effects of a rise in Ms?
1) Price level
2) Income
3) Expected inflation
What is the price-level effect when Ms increases?
If Ms increases, PL increases, thus more money is needed and Md increases making interest rate increase.
What is the expected-inflation effect when Ms increases?
If Ms increases, inflation increases, thus expected inflation increases, PL increases and interest rate increases (price-level effect).
What happens to the interest rate when the liquidity effect is larger?
The interest rate will decline sharply due to the liquidity effect, the other effects will raise it but it will finally settle at a level below its original value.
What happens to the interest rate when the liquidity effect is smaller?
The interest rate will decline limitedly due to the liquidity effect, the other effects will raise it to both counter the liquidity effect and surpass it. The interest rate thus finally settles at a level above its original value.
What happens to the interest rate when the expected-inflation is larger?
The liquidity effect is completely blocked by the expected-inflation effect and continues to increase with the other effects. The final interest rate thus settles at a level above its original value.
What are the time-lags of the liquidity, expected-inflation, income and price effects?
Liquidity is short-term. Exp-inflation and price effects are long-term.
