Chapter 5Asset – a piece of property that is a store of value.Determinants of Asset Demand- Wealth – total resources owned by the individual, including all assets.- Expected return -- (the return expected over the next period) on one asset relative to alternative assets.- Risk – the degree of uncertainty associated with the returnon one asset relative to alternative assets.- Liquidity – the ease and speed with which an asset can be turned into cash relative to alternative assets.Theory of Portfolio ChoiceHolding all other factors constant – 1. The quantity demanded of an asset is positively related to wealth.2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets.3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets.4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.Supply and Demand in the Bond MarketDemand – relationship between the quantity demanded of bonds and the price of bonds when all other variables are held constant.Remember that the bond demanders have excess funds. They are the lenders in our model.Develop graph here.Supply – relationship between the quantity supplied and the price when all other economic variables are held constant.Remember that the bond suppliers are those that need to borrow.Develop graph here.Market Equilibrium occurs when quantity demanded equals quantity supplied at the point where the demand curve and thesupply curve intersect (cross each other). This point gives the equilibrium price and the equilibrium interest rate since each price is associated with a specific yield.The market will always move toward equilibrium. If there is excess supply (quantity supplied is greater than quantity demanded) price will fall (interest rates will rise). If there is excess demand (quantity demanded is greater than quantity supplied) price will rise (interest rates will fall).Develop graph here.Change in bond price = change in quantity demanded = move along the existing bond demand curve.Factors that shif bond demand1. Wealth – increase shift bond demand right2. Expected returns relative to other assetsOther assets expect an increase in returns – bond demand decreases (shift left)Expected interest rates to increase – bond demand decreases (shift left)Expected inflation increases – bond demand decreases (shift left)3. Risk of bonds increases relative to other assets – bond demand decreases (shift left)4. Liquidity of bonds increases relative to other assets – bond demand increases (shift right)If the price of bonds changes, quantity supplied of bonds changes, move along the existing supply curve.Factors that shif bond supply1. Expected profitability of investment opportunitiesBusiness cycle expansion – bond supply increasesBusiness cycle recession – bond supply decreases2. Expected inflation – real cost of borrowing falls, bond supply increases3. Government budget needsBudget deficit – bond supply increasesBudget surplus – bond supply decreasesFisher Effect – change in the interest rate due to expected inflationExpected inflation increasesBond demand decreasesBond supply increasesBond price falls – interest rates increaseBusiness cycle expansionBond supply increasesBond demand increases (wealth up)Bond supply moves more than bond demand thus bond prices fall and interest rates increaseLiquidity Preference FrameworkDetermining equilibrium interest rates using the market for money. The interest rate determined using the market for money is the same that would be determined using the bond market.Develop graph here.Factors that shift the demand for money.Income Effect – more transactions mean that demand for money increases (shift right)Develop graph here.Price-level Effect – higher prices means higher demand for money to make transactions (shift right)Develop graph here.Money Supply shifts when the central bank (the U.S. Federal Reserve) changes it. An increase in the money supply shifts the curve to the right.Develop graph here.Impact of money supply changes over timeLiquidity effect – initial response of the interest rate to an increase or decrease of the money supply by the central bank. Money supply increase causes interest rates to fall.Income effect – money demand responds to higher or lower income. Money demand increase causes interest rates to rise.Price – level effect – money demand responds to higher prices. Money demand increase causes interest rates to rise.Expected-inflation effect – if consumers believe that higher prices will continue, the money demand curve continues to shiftright. Money demand increase causes interest rates to rise.The liquidity effect moves the interest rate in the opposite direction to the three effects that shift the money demand