ECO 3223 02 EVANS STUDY GUIDE FOR EXAM 2 CHAPTER 5 Know all of the key terms for this chapter Asset market approach an approach to determine asset prices using stocks of assets rather than flows Demand curve a curve depicting the relationship between quantity demanded and the price when all other economic variables are held constant Excess demand a situation in which quantity demanded is greater than quantity supplied Excess supply a situation in which quantity supplied is greater than quantity demanded Expected return the return on an asset expected over the next period Fisher effect the outcome that when expected inflation occurs interest rates will rise named after the economist Irving Fisher Liquidity the relative ease and speed with which an asset can be converted into cash Liquidity preference framework a model developed by John Maynard Keynes that predicts the equilibrium interest rates on the basis of the supply of and demand for money Market equilibrium a situation occurring when the quantity that people are willing to buy demand equals the quantity that people are willing to sell supply Opportunity cost the amount of interest expected returns sacrificed by not holding an alternative asset Risk the degree of uncertainty associated with the return on an asset Supply curve a curve depicting the relationship between quantity supplied and the price when all other economic variables are held constant Theory of asset demand the theory that the quantity demanded of an asset is 1 usually positive related to wealth 2 positively related to its expected return relative to alternative assets 3 negatively related to the risk of its return relative to alternative assets 4 positively related to its liquidity relative to alternative assets Wealth all resources owned by an individual including all assets 1 2 Why do interest rates fluctuate Bonds and interest rates are inversely related When bond prices go up interest rates go down and vise versa Interest rates fluctuate because bond prices move According to the Theory of Asset Demand what factors will shift the Demand Curve for bonds Make sure you know in which direction an increase decrease will shift the curve Pg 99 Table 2 Wealth Expected interest rates Expected inflation Riskiness of bonds relative to other assets Liquidity of bonds relative to other assets 3 According to the Theory of Asset Demand what factors will shift the Supply Curve for bonds And in 1 Which direction with an increase decrease pg 101 Profitability of investments Expected inflation Government deficit 4 What is the impact upon bond prices and interest rates of a b c an increase in expected inflation Bond price drops Interest rates increase a business cycle expansion Bond price drops inters rates increase a business cycle contraction Bond price increases interest decreases 5 The bond market represents the general level of longer term interest rates the money market for short term rates What factors determine and shift the supply and demand for money What do we mean by stating that the interest rate is the opportunity cost of holding money Demand Income effect price level effect pg 111 Supply Changes in income Changes in the price level Changes in the money supply pg 113 Interest rate Opportunity cost the amount of interest expected return sacrificed by not holding the alternative asset As the interest rate on a bond I rises the opportunity cost of holding money rises thus money is less desirable and the quantity of money demand must fall 6 Be able to draw the model of supply and demand for money and indicate how a shift in either demand or supply will affect short term interest rates Figure 8 equilibrium on page 110 Pg s 112 114 help with this Table 4 on page 112 is the answer What is the secondary and undesirable economic effect of a decrease in short term interest rateswhich 7 results from an increase in the supply of money In other words why do we say that the Fed can target either inflation or interest rates but not both When you increase the money supply interest rates fall When you decrease the money supply interest rates rise It s an either or proposition you can t do both If an increase in the supply of money leads to lower interest rates and inflation in the short run why do 8 we actually see interest rates rising What is the Fisher Effect This refers to the liquidity effect An increase in the supply of money would normally lower interest rates however there are other changes that occur and these might be stronger than the liquidity effect and in turn make the interest rates rise Fisher Effect When expected inflation rises interest rates will rise named after Irving Fisher 9 Describe Keynes liquidity preference framework in terms of the income and price level effects P 111 2 Income 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 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 CHAPTER 6 Know all of the key terms for this chapter Credit rating agencies investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default Default a situation in which the party issuing a debt instrument is unable to make interest payments or pay off the amount owed when the instrument matures Default free bonds bonds with no default risk such as US government bonds Expectations theory the proposition that the interest rates on a long term bond will equal the average of the short term interest rates that people expect to occur over the life of the long term bond Inverted yield curve s yield curve that is downward sloping Junk bonds bonds with ratings below Baa or BBB that have a high default risk Liquidity premium theory the theory that the interest rates on a long term bond will equal an average of the short term interest rates expected to occur over the life of the long term bond plus a positive term liquidity premium Preferred habitat theory a theory that is closely related to liquidity premium theory in which the interest rate on a long term bond equals an average of short term interest rates expected to occur over the life of the long term bond plus a positive term premium Risk premium the spread between the interest rate on bonds with default risk and the interest rate on Risk structure of interest rates the relationship among the interest rates