ECO 3223 EVANS STUDY GUIDE FOR EXAM 2 CHAPTER 5 Understand the following 1 2 The significance of the bond market to the U S economy why interest rates in capital markets fluctuate Bond market allows firms to maximize research and development ideas in a more timely matter Interest rates fluctuates because supply and demand fluctuates The Theory of Asset Demand know in which direction an increase decrease will shift the curve The quantity demanded of an asset is positively related to wealth The quantity of a demanded asset is positively related to its expected return relative to The quantity demanded of an asset is negatively related to the risk of its returns relative to The quantity demanded of an asset is positively related to its liquidity relative to alternative 3 Factors that will shift the Demand Curve for bonds and factors that will shift the Supply Curve for bonds and in which direction with an increase decrease alternative assets alternative assets assets a Demand Curve the right Wealth in an expansion with growing wealth the demand curve for bonds shifts to Expected Interest Rate higher expected interest rates in the future lower the expected return for long term bonds shifting the demand curve to the left On the contrary if expected interest rates go down in the future long term bond prices would rise and have a higher expected return shift demand to the right Expected Inflation an increase in the expected rate of inflations lowers the expected return for bonds demand curve shift to the left Risk an increase in the riskiness of bonds causes demand curve to shift to the left Liquidity increased liquidity of bonds results in demand curve shifting right b Supply Curve shifts to the right to the right Expected profitability of investment opportunities in an expansion the supply curve Expected inflation an increase in expected inflation shifts the supply curve for bonds Government budget an increase in budget deficits shifts the supply curve to the right 4 The impact upon bond prices and interest rates of any shift in Demand or Supply especially a b an increase in expected inflation A rise in expected inflation shifts the bond demand curve to the left and shifts the bond supply curve right causing the price of bonds to fall and the equilibrium interest rate to rise a business cycle expansion will shift the bond supply curve to the right and the demand curve for bond to the right less amount therefore the price of bonds will fall and the equilibrium interest rate will rise 1 c d e f 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 When Bd Bs there is excess demand price will rise and interest rate will fall When Bd Bs there is excess supply price will fall and interest rate will rise 4 5 6 Factors that determine and shift the supply and demand for money what is meant by stating that the interest rate is the opportunity cost of holding money As the interest rate increases the OPPORTUNITY COST of holding money increases the relative expected return of money decreases therefore the quantity demanded of money decreases Demand for money 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 Supply of money Assuming the supply of money is controlled by the central bank an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right The model of supply and demand for money and indicate how a shift in either demand or supply will affect short term interest rates 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 interest rate will rise via the increased prices 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 The secondary and undesirable economic effect of a decrease in short term interest rates which results from an increase in the supply of money Why do we say that the Fed can target either inflation or interest rates but not both Inflation The Fed cannot do both because when you increase the money supply inflation rise When inflation goes up interest rate goes down in order to get the economy moving before inflation rises again 8 The Fisher Effect nominal versus real rates and its impact upon the effects of monetary policy Implies that there is a real interest rate When expected inflation rises interest rates rises If we think inflation will be positive lenders demand will be less willing to lend If you have money available to lend you could either spend now or get paid later But with inflation prices will rise and you will want to spend now Borrower supply will be more willing to borrow Borrowers can buy now from borrowing or wait borrow and buy later But prices will be higher later so you want to borrow and buy now Inflation leads to rising interest rates in the long run 2 9 Keynes liquidity preference framework in terms of the income and price level effects a Income effect right b Price level effect Higher income causes demand for money and interest rates to increase and demand shifts When income raises during business expansion interest rates rises Rise in price level causes demand for money at each interest rate to increase and demand curve shifts right Price level increases with the supply of money interest rates rise c Liquidity Preference framework Determines the equilibrium interest rate in terms of supply and demand for money As the interest rate increases the opportunity cost of holding money increases the relative expected return of money decreases therefore the quantity demanded of money increases CHAPTER 6 1 Understand how default risk liquidity and income tax considerations affect bond prices and interest rates on bonds a Default risk probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value U S treasury bonds are considered default free Increase in default risk shifts demand curve for corporate bonds to the left