Lecture 4

Question 1

What determines quantity demanded of an asset?

Answer 1

i. Wealth: the total resources owned by the individual, including all assets.
ii. Expected return: the return expected over the next period on one asset relative to alternative assets.
iii. Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets.
iv. Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets.

Question 2

Theory of Portfolio choice

Answer 2

all other factors constant:
1 The quantity demanded of an asset is positively related to wealth.
2 The quantity demanded of an asset is positively related to its expected return relative to alternative assets.
3 The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets.
4 The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.

Question 3

What is the relationship between bond prices and supply and demand?

Answer 3

• At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship.
• At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship.

Question 4

Factors that shifts the demand curve for bonds

Answer 4

Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right.
Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left.
Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left.
Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left.
Liquidity: increased liquidity of bonds results in the demand curve shifting right.

Question 5

What is the liquidity preference framework?

Answer 5

The liquidity preference framework is a Keynesian model that determines the equilibrium interest rate in terms of the supply of and demand for money.
» Two main categories of assets that people use to store their wealth: money and bonds. » Total wealth in the economy: Bs −Bd = Md −Ms (1) » In equilibrium: money market Ms = Md and bond market Bs = Bd.

Question 6

As the interest rate increases:

Answer 6

» The opportunity cost of holding money increases… » The relative expected return of money decreases… …and therefore the quantity demanded of money decreases

Question 7

Shifts in the demand for money

Answer 7

» Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
» Price level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Question 8

Shifts in the supply of money:

Answer 8

» Assume that the supply of money is controlled by the central bank.
» An increase in the money supply engineered by the Bank of England will shift the supply curve for money to the right.

Question 9

Effects of an increase in money supply:

Answer 9

Income effect: liquidity preference and bond market suggest a rise in interest rates in response to the higher level of income.
Price level effect: a rise in interest rates in response to the rise in price level (prediction of the liquidity preference framework).

Expected inflation effect: a rise in interest rates in response to the rise in the expected inflation rate.
» Persists only as long as the price level continues to rise.
» A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero.