Topic 5 Flashcards
What is an asset market?
The entire set of markets in which people buy and sell real and financial assets
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
What are the 4 characteristics of assets that affect the portfolio allocation decision?
Expected return, wealth, risk, liquidity & time to maturity (for bonds)
What is the Fisher equation?
π πππ πππ‘ππππ π‘ πππ‘π (π) = πππππππ πππ‘ππππ π‘ πππ‘π (π) β ππππππ‘πππ πππ‘π(π)
r = i - pi
How do you calculate expected real return?
πΈπ₯ππππ‘ππ ππππ πππ‘π’ππ = πππππππ πππ‘π’ππ β ππ₯ππππ‘ππ ππππππ‘ππn
How do you calculate the relative return of asset a relative to asset b?
Ra / Rb
What does an increase in wealth do to quantity demanded of an asset?
All else equal, an increase in wealth raises the quantity demanded of an asset
What is risk?
Risk is the degree of uncertainty in an assetβs (nominal or expected real) return
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
What is liquidity ?
The ease and quickness with which an asset can be traded
What is the most liquid asset?
Money
Do investors prefer more liquid assets?
Yes
What is the equation for the demand function for a one-year discount bond?
i = R^e = F / Pb -1
R^e = expected return
F= Face value
Pb= Price of bond
What does a lower price of a bond imply?
A higher rate of return of bonds
What does the demand curve of bond show?
The relationship between the QD of bonds and the bond price
What are the factors that shift the demand curve for bonds?
Wealth
Expected return
Expected rate of inflation
Risk
Liquidity
How does wealth affect the demand for a bond?
Increase in wealth increases demand
How does expected return affect the demand for a bond?
An increase in a bondβs expected return relative to that of an alternative asset, increases the demand for a bond
In our unit, we only consider one-year discount bonds, what does this mean for the expected return of a bond?
R^e = i
How do you denote the expression for the relative return of a bon?
Look at slides
What does an increase in the expected rate of inflation do to the demand of bonds?
An increase in the expected rate of inflation lowers the demand of bonds
How does an increase in the expected rate of inflation cause a decrease in the demand for bonds?
Using the formula:
R^e = i (1 - t) - pi^e
Therefore the decrease will cause a fall in R^e
What is another effect of an increase in expected inflation?
Higher prices of real assets in the future, hence higher nominal capital gains
So, referring to the change in price of future real assets, how does an increase in expected inflation effect the demand for bonds?
Demand for bonds will fall because a rise in the expected returns on these real assets, that are expected to increase in price, will lower the expected return on bonds relative to the expected return on real assets
How does risk associated with the return on bonds effect the demand for bonds?
If this risk increases relative to that of alternative assets, the demand for bonds will decrease
How does liquidity effect the demand for bonds?
The demand for a bond rises as its liquidity increases relative to the liquidity of alternative assets
What does the supply curve of a bond represent?
Shows the relationship between the price of bonds and their quantity supplied
What do we assume about government bonds?
The government supply of bonds is independent of the bonds rate of return, and thus bond price, thus the government supply is a vertical line
Who issues bonds?
The government and private corporations
What does the private supply of bonds look like?
Upwards sloping
How is the aggregate supply of bonds calculated? I it upwards sloping?
Government supply + private supply
Yes
What shifts the supply curve of bonds?
Expected profitability of investment opportunities (business cycle expansion)
Expected inflation
Government budget deficits
How does the expected profitability of investment opportunities affect the private supply of bonds (related to business cycle)?
When opportunities for profitable investments are plentiful, firms are willing to borrow. Hence, in a business cycle expansion the supply of bonds goes up and the supply increases
How does expected inflation effect the supply of bonds?
For a given i, when expected inflation rises, the real cost of borrowing falls. QS on bonds increases.
How do government budget deficits effect the supply of bonds?
Higher government budget deficits increase the government supply of bonds
What is the effect called that outlines changes in the interest rate due to expected inflation?
The Fisher Effect
If you get a question on how a change in the interest rate due to expected inflation effects market equilibrium, what bullet points should you include?
- Increase in pi^e lowers expected real rate of return on bonds relative to real assets. Bond demand decreases
- Real cost of borrowing falls. Supply of bonds increases
What is the Fisher effect?
When expected inflation rises, interest rates will rise
What does the Fisher effect look like on a diagram?
Increase in supply
Decrease in the demand for bonds
What is the effect on bond price and bond quantity due to the Fisher effect?
Decreased price
Quantity change hard to determine (need to know magnitudes)
Outline the bullet points required when analysing equilibrium when there is a change in interest rates due to a business cycle expansion?
- National income rises, businesses are more willing to borrow because likely to have more profitable investment opportunities. Supply of bonds increases
- Wealth increases leading to an increase in bond demand
What happens to price and quantity when there is a business cycle expansion?
Price hard to determine
Quantity increases
Define money
assets that are widely used and accepted as payment
What are the 3 functions of money?
Medium of exchange: a device for making transactions
Unit of account: the basic unit for measuring economic value
Store of value: money can be used to hold wealth
What are monetary aggregates?
official measures of the money stock that differ in their definition of the concept of money
What is M1 monetary aggregates?
βCurrency and travelerβs checks held by the public
βTransaction accounts on which checks may be drawn
Does M1 or M2 have larger liquid assets?
M1
What are the assumptions we make about bonds compared to monetary assets?
Bonds are less liquid and pay interest
What is include din M2 monetary aggregates?
Savings deposits, small (<$100,000) time deposits, money market mutual funds (MMMF) balances, money-market deposit accounts (MMDAs)
What is the money supply?
The amount of money available in the economy
How do you calculate M2?
M2 = M1 + less βmoney likeβ assets
How does the central bank increase the money supply?
Using newly printed money to buy financial assets from
the public βan open market purchase
How does the central bank reduce the economyβs money stock?
Sells financial assets to the public to remove money
from circulation βan open market sale
What are open market purchases and sales called?
Open market operations
How else might the central bank increase the money supply?
By buying newly issued government bonds
directly from the government (mostly in the past)
What letter do we use in our analysis to denote the money supply?
Mbar = M^s
What does the money supply curve look like?
Vertical (money supply is independent of interest rates)
What is the demand for money?
The optimal quantity of monetary assets that people choose to hold in their
portfolios
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 determines peopleβs money holding decisions?
Depend on how much they value liquidity against the low return on money
What is the aggregate demand for money?
the sum of all individual money demands (π^π)
What are the macroeconomic variables that affect the money demand?
Price level
Real income
Interest rates
Wealth
Risk
Liquidity of alternative assets
Payment technologies
How does the price level effect the money demand?
The higher the price level, the more money you need for transactions
What is nominal money demand proportional to?
the price level
How does real income effect the money demand?
The more transactions individuals and businesses conduct, the greater is their demand for money
How do interest rates effect money demand?
An increase in the return on bonds decreases the demand for money.
An increase in the interest rate on money (π^π) leads to an increase in money demand
What is the nonmonetary assets interest rates known as?
the opportunity cost of holding money
What do we assume about i^m?
i^m = 0
What is the real rate of return on money?
rm = i^m - pi
Assuming that i^m = 0:
rm = -pi
In periods of high and erratic inflation what do people switch to? What are these?
Inflation hedges: assets whose real returns are less likely to be affected by inflation. Examples include gold, consumer durable
goods and real estate. We call these real assets.
What is the money demand fucntion?
π^π = π Γ πΏ(π, π)
M^d = nominal aggregate money demand
P = price level
L = real money demand function
Y = income
i = nominal interest rate on bonds
What is an alternative expression of the money demand function?
π^π = π Γ πΏ(π, π + π^π)
evoking Fisher equation
What is the equation for the real money demand?
M^d / P
How does wealth effect the demand for money?
When wealth increases money demand may increase
How does risk effect the demand for money?
βIf the risk of alternative assets increases, money demand may increase
βTimes of erratic inflation bring increased risk to money, as ππ may become quite uncertain (givena fixed nominal return π^π). Money demand in nominal & real terms declines.
How does liquidity of alternative assets effect the demand for money?
As alternative assets become more liquid, the demand for money declines
How does payment technologies effect the money demand?
Innovations in payment technologies reduce money demand
What is the income elasticity of money demand (πΌY)?
The % change in money demand caused by a 1%
change in income (π)
What do statistical studies show the income elasticity of money demand to be?
positive and less than one
What is the equation of πΌY?
βππ/βπ x π/π^d
What is the interest elasticity of money demand (πΌi)?
The % change in money demand caused by a
1% change in the interest rate (π)
What do statistical studies show about πΌπ?
small and negative
What is the equation of πΌi?
βππ/βπ x π/π^d
What is the price elasticity of money demand (πΌp) ?
The % change in money demand caused by a 1%
change in the economyβs price level (π)
What do statistical studies show about the price elasticity of demand?
it is close to 1, so money demand is proportional to P
What is the equation of πp?
βππ/βπ x π/π^π β 1
What is the liquidity preference framework?
A model for determining the equilibrium interest rate developed by John Maynard Keynes
What conditions is the equilibrium in the money market described by (liquidity preference framework)?
π^π = π^d
πbar/π = πΏ(π, π*)
In the liquidity preference framework, how do you calculate wealth?
The quantity of money demanded plus the quantity of bonds demanded
Β£π^π + Β£π΅^π = Β£W
In the liquidity preference framework, what do we assume happens to the public at the equilibrium interest rate?
At the equilibrium interest rate (π*) the public optimally chooses to hold the quantity of money
supplied by the Central Bank, thus π^π = π^π = Mbar
What happens in the liquidity preference framework when π > π*? What is the result of this?
There is an excess supply of money meaning that
individuals hold more money than they optimally want to.
Individuals start buying bonds and the demand for bonds rises.
The price of bonds in the bonds market rises implying that the interest rate falls.
What happens in the liquidity preference framework when π < π*? What is the result of this?
There is an excess demand for money meaning that
individuals hold less money than they optimally want to.
People start selling bonds leading to a fall in the price of bonds in the bonds market.
The interest rate rises until it reaches the level π*.
If the economy is at full employment, all markets are at equilibrium. What is the equation of the economyβs price level and what is it determined by? What does this equation state?
π =πbar / πΏ(π, π+π^π)
Determined by the asset market equilibrium condition
The price level is proportional to the nominal money supply
What is the liquidity effect?
An increase in the money supply will lower interest rates
What happens in the liquidity preference framework when there is an increase in money demand?
π^π β ππ₯πππ π ππππππ πππ π β β ππ’ππππ¦ ππ πππππ β β ππ΅ β β i
What happens in the liquidity preference framework when there is an increase in the supply of money?
π^π β ππ₯πππ π π π’ππππ¦ ππ π β β π·πππππ πππ πππππ β β ππ΅ β β i
Why does an increase in the money supply cause the interest rate to fall?
Because of the liquidity effect
What does falling real interest rates lead to in terms of investment and aggregate demand?
Private investment spending (πΌ^π)
and thus aggregate demand (πππ) rise
What are the 3 other effects of an increase in the money supply?
Income effect
Price-level effect
Expected-inflation effect
What is the income effect in terms of an increase in money supply?
The rise in aggregate supply and national income (π) leads to an increase in money demand and thus an increase in the nominal interest rate (liquidity preference framework)
What is the price-level effect in terms of an increase in the money supply?
A one-time increase in the money supply will cause prices to rise to a permanently
higher level by the end of the year. Will lead to an increase in interest rates.
What is the expected-inflation effect in terms of an increase in the money supply?
A one-time increase in the money supply will cause prices to rise to a permanently
higher level by the end of the year. The bonds supply and demand framework has shown that an increase in expected inflation will lead to
a higher level of interest rates.
How long does the expected-inflation effect persist for?
Only as long as the price level continues to rise
After a change in the money supply, how long does it take each effect to come into play?
The liquidity effect takes effect immediately whereas the income and price-level effects take longer to
work
How do you determine whether interest rates will rise or fall from an increase in the money supply?
If the income-, price-level-, and expected inflation effects are substantial, it is possible that when
money supply increases, interest rates might also increase
What determines the speed of the expected inflation effect?
Can be slow or fast depending on whether people adjust their expectations of inflation slowly or quickly when the money supply increases
Look at slide 79 to see diagrams
What does research show when the money supply increases?
Research shows that increased money growth temporarily lowers short-term interest rates.
