Chapter 5 The Behavior of Interests Rates I Determinates of Asset Demand a Wealth total resources owned by the individual Increasing wealth increaseses quantity demand of an asset i return expected over a period on one asset relative to b Expected Return alternative assets i An increase in an asset expected return relative to that of an alternative asset holding everything else unchanged raises the quantity demanded of the asset the degree of uncertainity associated with the return on one asset c Risk relative to alternative assets if the risk of an asset rises relative to that of alternative assets its quantity demanded will fall the ease and spped which an asset can be turned into cash d Liquidity relative to alternative assets the more liquid an asset is the more desirable it is and the greater the quantityu demand will be i i e Theory of Asset Demand i The QD of an asset is positively related to its wealth ii The QD of an asset is positively related to its expected return iii The QD of an asset is negatively related to the risk of its returns relative to an alterbnative asset relative to alternative assets iv The QD of an asset is positively related to its liquidity relative to II Supply and Demand in the Bond Market alternative assets a When interest rates are lower it is less costly to borrow by issuing bonds firms will be willing to borrow more through bond issues and QD of bonds goes up b Deamand Curve i As expected return increases the quantity of demand increases as well c Supply Curve i As the price increases the quantity supplied increases d Market Equilibrium equals the amount that people are willing to sell supply at a given price Quantity of bonds supplied exceeds the quantity of amount that people are willing to buy demand i Excess Supply bonds demanded Driving prices down of bonds demanded Driving prices up ii Excess Demand quantity of binds supplied is less that the quantity a Whend Quantity Demanded Supplied changes as a result in the change in the price of the bond movement along the demand supply curve b Shift in Demand Supply curve occurs when the the quantity demanded supplied changes at each given price interest rate of the bond III Change in Equilibrium Interests Rates in response to a change on some factors besides the bonds price or interests rate c Shifts in Demand for Bonds i Wealth ii Expected Returns 1 2 in business cycle expansion with growing wealth the demand for bonds rises and the demand curve for bonds shifts to the right In a business recession when income and wealth fall the demand for bonds falls and the demand curve shifts to the left 3 Propensity to save peoples desire to save Increases then Bond Prices shift to the right a b Decrease then bond prices shift to the left 1 1 year bonds and 1 year HPR only thing that effects them is current interet rate 2 Higher Expected interests rates in the future lower the expected return for long term bonds decrease the demand and shift the demand curve to the left 3 Lower expected interest rates in the future increase the 4 5 demand for long term bonds and shift the demand curve to the right If people are optimistic about stocks people will move money out of bonds into stocks and thus lower demand and shift demand curve to the left increase in inflation will lead to higher prices on other real assets houses cars and thus higher nominal capital gains Lead to a fall in the expected returns of bonds related to real assets and cause demand for bonds to fall and shift demand curve to the left 1 An increase tin the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left Increase in the riskiness of Alternative Assets causes the demand for bonds to rise and the demand curve to shift to the right 2 1 2 Increase in liquidity of bonds results in an increased demand for bonds and the demand curve shifts to the right Increased liquidity of Alternative Assets lowers the demand for bonds and shifts the demand curve to the left iii Risk iv Liquidity d Shifts in supply of Bonds i Expected Profitability of Investment Opportunities 1 The more profitable investment in plant equipment and other equipment a firm expects tp make the more willing it is to borrow to finance it a b In a business cycle expansion the supply of bonds increases and the supply curve shifts to the right In a Recession when there are far fewer expected profitable investment opportunities the supply of bonds falls and the supply curve shifts to the left ii Expected inflation 1 An increase in the expected inflation rate causes the supply of bonds to increase causing a shift to the right a Real cost of borrowing falls and Quantity of bonds supplied increases at any given price iii Government Budget 1 High government deficits increase the supply of bonds and shifts the supply curve to the right IV Supply and Demand in the Market For Money The Liquidity Preference Framework a Liquidity Preference Framework in terms of the supply and demand for money i 2 main assets people use to store wealth determines the equilibrium interests rate money 1 2 Bonds ii BS MS BD MD 1 Bs Quantity of Bonds Supplied 2 Ms Quantity of Money Supplied 3 BD Quantity of Bonds Demanded 4 MD Quantity of Money Demanded iii BS BD MS MD 1 Meaning if Money demanded and Money supplied are in equilibrium then Bonds are in equilibrium as well b Deals with change in income price levels and money supply c See Figure 8 on Page 110 V Changes in EQ Interests Rates in the Liquifify Preference i a Shifts in the Demand for Money Income Effect as an economy expands and income rises wealth increases and people will want to hold more money as a store of value People will want to carry out more transactions using money as a medium of exchange with the result that they will also want to hold more money 1 Higher levels of income causes the demand curve for money at each interest rate to omcrease and the demand curve to shift to the right a When income rises interests will rise ii Price Level Effect of the goods and service that one can buy Same amount of nominal money is no longer valuable amount of money in real terms goes up in terms 1 a shift in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right a When price levels rise interst rates will rise b Shifts in the Supply of Money i Completely controlled by the federal banks ii An increase in the money supply engineered by the federal reserve will