ECN 506 Lecture Notes - Lecture 4: Liquidity Preference, Economic Equilibrium, Shortage

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28 Mar 2018

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Chapter 5 the behavior of interest rates. To understand why bonds prices and interest rates change, we make use of the supply and demand analysis for bond markets and markets for money. * see lecture 4 slideshow, slide 8 for equation. Bond demand: holding all else constant, lower prices (higher interest rates) increases the quanitity demanded of bonds. Interest rate and quantity demanded are positively related. Bond supply: holding all else constant, lower prices (higher interest rates), decreases the quantity supplied of bonds. Market equilibrium: when d > s, there is excess demand, price will rise and interest rate will fall, when d < s, there is excess supply, price will fall and interest rate will rise. Movement along the demand (or supply) curve: when quantity demanded (or supplied) changes because of a change in the price of the bond (or, equivalently, a change in the interest rate)

Related Questions

1) Assets can be classified in 3 ways according to its liquidity. However, such assets do not include homes, jewelry, vehicles, etc. Why? (use three sentences maximum)

2) People often like to visit flea markets to look for unexpected opportunities. Flea markets also typically use cash. Explain why this is an example of the liquidity demand for money.

3) What would happen to the supply of money if a central bank purchased long-term government bonds held by the public?

4) If investors began to think the stock market is becoming less risky, how will this belief affect the demand for money? Would this more likely affect M1 or M2?

5) Suppose the interest rate on a two-year bond was higher than the interest rate on a one-year bond. What does the market believe will happen next year to one-year interest rates?

Problem 2 (15 points)

Consider an economy with five assets: 1) Cash 2) Checking Accounts 3) Savings and Money-Market Accounts 4) Bonds 5) Stocks. M1 includes asset classes 1 and 2, and M2 is the sum of M1 and asset class 3. All else being equal, how would each of the following changes affect demand for M1? And for M2? Explain.

a) The stock market crashes, and investors who were previously excited about prospective gains now view it as too risky.

b) Authorities intensify the fight against street crime, leading to more arrests and convictions for robbery. As crime rates fall, people feel safer holding cash.

c) Banks introduce overdraft protection, under which funds are automatically transferred from savings to checking as needed to cover checks.

d) Due to an increase in inflation expectations, the average interest rate on bonds rises from 3% to 6%.

e) The government introduces deposit insurance, guaranteeing checking, and savings deposits in the event that there are depositor runs and banks fail.

Hint: Each change in a-e makes one asset more (less) attractive by raising (lowering) its return, liquidity, safety, or another desirable characteristic of the asset. You need to identify which asset's attractiveness has increased (decreased) and will thus absorb more (less) funds. As agents change their portfolios, there may be several possibilities regarding where funds come from (flow to). Thus, different answers may be correct, as long as you write a sentence explaining the move you have in mind. The emphasis of the question is on demand. That is, you just need to think through how an individual would reallocate funds between different available assets. Do not try to guess further equilibrium effects, i.e., do not worry about what would happen to prices and other behaviors that might follow if everyone in the economy did this move. That is interesting but beyond the scope of this problem. Also, assume that these are ceteris paribus changes, i.e., other factors do not change.

taupesheep43

Why do CDs have lower rates of return than stocks?

CDs are much riskier investments than stocks.

CDs are less risky than stocks.

CDs are not taxed while stock s returns are taxable.

CDs are not as liquid as stocks.

Given that most investors tend to be risk averse,

	no one buys risky assets.
	there's a trade-off between risk and return.
	low risk assets provide the best return.
	it must be a superior strategy compared to one that is risk loving.

Which of the following financial assets has both the highest risk and highest return for the period of 1926-2009?

	small company stocks
	large company stocks
	corporate bonds
	Treasury bills

Since all assets typically do not move together, how can investors typically reduce risk?

	purchase only the best performing assets
	diversify one's portfolio across different asset classes
	avoid poor performing assets
	actively manage one's portfolio

Risk that is common to all assets (e.g., common stocks) of a certain type is referred to as

	systematic risk.
	unsystematic risk.
	idiosyncratic risk.
	structural risk.

Which is the best example of idiosyncratic risk?

	a financial crisis
	a lawsuit because the corporation produced a faulty product
	a recession
	rising interest rates

If market participants rely only past stock prices to forecast future stock prices,

	they will be better able to forecast future price increases than future price decreases.
	they will be better able to forecast future price decreases than future price increases.
	they have adaptive expectations.
	they have rational expectations.

ECN 506 Lecture Notes - Lecture 4: Liquidity Preference, Economic Equilibrium, Shortage

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