ECON 311 1st Edition Lecture 6 Outline of Last Lecture I. Theory of Asset DemandII. A Model: The Market for BondsIII. Increases and Decreases in Bond Demand and SupplyOutline of Current Lecture I. Bond MarketsII. Two Applications of the Bond Market ModelIII. Liquidity Preference ModelIV. Effects of an Increase in Money SupplyCurrent LectureChapter 4: The Behavior of Interest RatesI. Bond MarketsEX: Suppose stock prices become more volatile, what will happen to the bond market?If stock prices go up, the demand for bonds will increase (B2D) causing the price of bonds to rise and the interest rate to fall.II. Two Applications of the Bond Market Model1. Fisher Effect – “What happens to interest rates when expected inflation increases?”These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. B2DP (Bond Price)B (quantity of bonds)BSB1D(i1) P1(i2) P2Expected inflation decreases demand for bonds (B2D) and increases the supply of bonds (B2S)Increases in expected inflation decrease bond prices and increase interest rates.2.Interest Rates and the Business Cycle – “Are interest rates Pro-Cyclical or Counter-Cyclical?”Assume: That there is a recession so the GDP falls indicating a decrease in wealthThe decrease in bond demand (B2D) pushes interest rates up (and bond prices down) and the decrease in the supply of bonds (B2S) pushes interest rates down making the model ambiguous. So we ask “Which curve shifts more?”Using collected data (graphs in book) we can conclude that during an expansion interest rates rise and during a recession interest rates fall. Making interest rates a PRO-CYCLICAL variable. This means that the effect on thesupply of bondsusually has a largereffect than theeffect on demand.III. LiquidityPreferenceModelAssumptions: Wealth can either be held in bonds (which accumulate interest) or in money (which does not accumulate interest)Demand for MoneyP (Bond Price)B (quantity of bonds)B1SB1D(i1) P1B2S(i2) P2B2DP (Bond Price)B (quantity of bonds)B1SB1D(i1) P1 = (i2) P2B2SB2DIf money doesn’t pay interest then interest is the opportunity cost of holding moneyIf you expect interest rates to fall then you’re expecting bond prices to rise so you’d want to hold less money and more bonds. This assumes that there is a normal interest rate that the market is always moving towardsSupply forMoney(Determined by theCentral Bank)Equilibrium forMoneyFactors that Shift the Demand and Supply of Money1. Changes in incomea. Increase in income increases the demand for moneyInterest RateQuantity of Money DemandedMSMDi*Interest RateQuantity of moneyMD – money demand curveInterest RateQuantity of moneyMS – money supply curvei. When you have more income you want to buy more goods therefore you need more money (Liquidity is important here)2. Changes in Price Levela. Increase in price level increase the demand for moneyi. When you want to continue to buy the same good but the price has increased you need more money3. The Central Bank can shift the money supply curveImpact of an INCREASE in money supplyThe interest rate falls when money supply increases. This is called the LIQUIDITY EFFECT of an increase in Money supply. Page 99 of the textbook has three graphs of the effect this has in a real world situation that includes the effects of Income, Price-Level, and Inflation effectsIV. Effects of an Increase in Money Supply1.Liquidity Effect– ifmoneysupplyincreases then interest rates fall2. Income Effect – if money supply increases the income rises which cause interest rates to rise3. Price Level Effect – if money supply increases the price of goods rise which cause demand form money to increase which raises interest rates4. Expected Inflation Effect – if money supply increases inflation expectations increase which lowers bond prices which raises interest rates (Fisher Effect)The most common effects of an increase in money supply are show on page 99 in the middle graph, where there is first a decrease in the interest rate during the liquidity effect and then the interest rate rises to higher than its previous rate because of the other effects.Interest RateQuantity of moneyMS – money supply curvei1i2PFactors that increase the demand for