Topic 4- The Asset Market, Money & Prices Flashcards
What is the asset market?
The entire set of markets in which people buy and sell real and financial assets
Give 4 examples of assets traded in the asset market
- Gold
- Houses
- Bonds
- Stocks
What is portfolio theory?
A theory that specifies the determinant factors of the demand for assets
What is a portfolio?
The set of assets that a holder of wealth chooses to own
What is the portfolio allocation decision?
The decision about which assets and how much of each asset to hold
Give 5 main characteristics of assets which affect the portfolio allocation decision
- Wealth
- Expected return
- Risk
- Liquidity
- Time to maturity (for bonds)
How does wealth affect the portfolio allocation decision?
Ceteris paribus, an increase in wealth raises the quantity demanded of an asset
How does expected return affect the portfolio allocation decision?
Ceteris paribus, investors want assets with the highest expected return
What is the rate of return to an asset?
The rate of increase in its value per unit of time
What is the expression for the relative return of an asset ‘A’?
R_a/R_b
How does risk affect the portfolio allocation decision?
Ceteris paribus, investors prefer assets with low risk
What is the risk of an asset?
The degree of uncertainty in an asset’s return
What is the expression for the relative risk of an asset ‘A’?
Risk_a/Risk_b
What is the risk premium?
The amount by which the expected return on a risky asset exceeds the return on an otherwise comparable safe asset
How does liquidity affect the portfolio allocation decision?
Ceteris paribus, investors prefer more liquid assets
What is liquidity?
The ease and quickness with which an asset can be traded
What is the formula for the relative liquidity of an asset ‘A’?
Liq_a/Liq_b
What is the time to maturity of a bond?
The amount of time until a financial security matures, and the investor is paid the principal
What is the formula for the expected return on a bond?
Expected return = Face value/Price of bond - 1
R^e = F/P_b - 1 = i
How would an increase in interest rates affect demand for bonds?
Higher interest rates make bond payments less attractive so it reduces demand
How would an increase in the expected rate of inflation affect the demand for bonds?
Higher expected inflation lowers the expected real interest rate on bonds causing their demand to decline
How is the demand for a bond related to its liquidity?
The demand for a bond is positively related to its liquidity relative to the liquidity of assets
What does the supply curve for government bonds look like?
It is completely vertical with a gradient of infinity
How does the interest rate affect the supply of private bonds?
When the interest rate is lower, the price of bonds is higher therefore it is less costly for firms to borrow by issuing bonds so they supply more
How is the aggregate supply curve of bonds derived?
By horizontally summing the private and government supply curves
What are 3 main factors that shift the supply of bonds?
- Expected profitability of investment opportunities
- Expected inflation
- Government budget deficits
How does the expected profitability of investment opportunities affect the supply of bonds?
When opportunities for profitable investment are plentiful, firms are willing to borrow to finance these investments
How does expected inflation affect the supply of bonds?
For a given interest rate, when expected inflation rises, the real cost of borrowing falls. Thus, the quantity supplied of bonds increases.
How do government budget deficits affect the supply of bonds?
Higher government deficits increase the government supply of bonds and shift the aggregate supply curve to the right
What is the Fisher effect?
When expected inflation rises, interest rates will rise
How does a business expansion affect bond prices?
It’s ambiguous, the price of bonds can either rise or fall
How can a business expansion increase bond prices?
As an economy expands, wealth increases leading to an increase in bond demand
How can a business expansion decrease bond prices?
When national income rises, businesses are more willing to borrow because they are likely to have many profitable investment opportunities. Thus, the supply of bonds increases causing the equilibrium price of bonds to fall
What is the economic definition of money?
Assets that are widely used and accepted as payment
What are the 3 main functions of money?
- Medium of exchange
- Unit of account
- Store of value
What are money aggregates?
Official measures of the money stock that differ in their definition of the concept of money
Describe the M1 aggregate
Currency & traveller’s checks held by the public, transaction accounts on which checks may be drawn
Describe the M2 aggregate
The components of M1 plus savings deposits, small time deposits, MMMF balances, MMDAs
What is an MMMF?
Money market mutual fund
What is an MMDA?
Money market deposit account
What is the money supply?
The amount of money available in an economy
What is an open market purchase?
When the central bank increases money supply by using newly printed money to buy financial assets from the public
What is an open market sale?
When the central bank sells financial assets to the public to remove money from circulation and reduce the money supply
What is the benefit of holding money?
Money is the most liquid asset
What is the cost of holding money?
Money pays a low return
What do peoples’ money-holding decisions depend on?
Depends on how much they value liquidity against the low return on money
What are the 4 macroeconomic variables that affect money demand?
- Price Level
- Real Income
- Interest Rates
- Rate of return on money
How does the price level affect money demand?
The higher the price level, the more money you need for transactions so nominal money demand is proportional to the price level
How does real income affect money demand?
The more transactions individuals and businesses conduct, the greater is the demand for money and real income is a prime determinant of the number of transactions
How do interest rates affect money demand?
The interest rate on bonds is the opportunity cost of holding money so an increase in the return on bonds decreases the demand for money
How does the rate of return on money affect money demand?
When the rate of return on money reduces, so does its demand
What is the money demand function?
Nominal aggregate money demand = Price level x Real money demand function(real income, nominal interest rate on bonds)
M^d = P x L(Y,i)
What is the expression for the real money demand?
M^d/P
What are 4 other factors affecting money demand?
- Wealth
- Risk
- Liquidity of alternative assets
- Payment technologies
How does wealth affect money demand?
When wealth increases, money demand may increase
How does risk affect money demand?
If the risk of alternative assets increases, money demand may increase
How does liquidity of alternative assets affect money demand?
As alternative assets become more liquid, the demand for money declines
How do payment technologies affect money demand?
Innovations in payment technology reduce money demand
What is the income elasticity of money demand (η_y)?
The % change in money demand caused by a 1% change in income (Y)
What is the interest elasticity of money demand (η_i)?
The % change in money demand caused by a 1% change in the interest rate (i)
What is the price elasticity of money demand (η_p)?
The % change in money demanded caused by a 1% change in the economy’s price level (P)
What is the relationship between wealth and the demand for money & bonds?
The quantity of money demanded plus the quantity of bonds demanded must be equal to the total amount of wealth
£M^d + £B^d = £W
How much money does the public optimally choose to hold at the equilibrium interest rate?
The quantity of money supplied by the central bank, thus M^d = M^s
What happens when the interest rate is greater than the equilibrium interest rate on bonds (i>i*)?
There’s an excess supply of money which means that individuals hold more money than they optimally want to so they start buying bonds so the demand for bonds rises
What happens when the interest rate is less than the equilibrium interest rate on bonds (i<i></i>
There’s an excess demand for money meaning that individuals hold less money than they optimally want to so people start selling bonds leading to a fall in the price of bonds due to the higher supply
What is the asset market equilibrium condition?
P = M^s/L(Y,r+π^e)
What is the liquidity effect?
An increase in the money supply will lower interest rates
What is the income effect?
The rise in aggregate supply and national income (Y) leads to an increase in money demand and this an increase in the nominal interest rate
What is the price level effect?
A one-time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year
What is the expected-inflation effect?
An increase in the money supply may lead people to expect a higher price level in the future, and hence higher inflation
