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ECON 2035- Final Exam Guide - Comprehensive Notes for the exam ( 63 pages long!)


Department
Economics
Course Code
ECON 2035
Professor
B.Sharkey
Study Guide
Final

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LSU
ECON 2035
FINAL EXAM
STUDY GUIDE

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Chapter 5 Book Notes
ECON 2035The Behavior of Interest Rates
Determinants of Asset Demand
Assetpiece of property that is a store of value
o Money, bond, stock, art, land, house, farm equip., manu. machinery
Wealthtotal resources owned by individual, including all assets
Expected Return(return expected over next period) on one asset relative
to alternative assets
Risk(degree of uncertainty associated w/ return) on one asset relative to
alternative assets
Liquidity(ease & speed an asset can be turned to cash) relative to
alternative assets
Wealth
Holding everything else constant, increase in wealth raises quantity
demanded of an asset [b/c you have more resources available to purchase]
Expected Returns
An increase in an asset’s expected return relative to that of an alternative
asset, holding everything else unchanged, raises the quantity demanded of
the asset
Risk
Holding everything else constant, if an asset’s risk rises relative to that of
alternative assets, its quantity demanded will fall
o I.e. if an airline has return of 15% half the time & 5% the other half, it
has expected return of 10%. But if bus company has fixed return of
10%, most risk-adverse people will choose a bus
Liquidity
The more liquid an asset I relative to alternative assets, holding everything
else unchanged, the more desirable it is and the greater quantity demanded
will be [house not liquid. US treasury bill market w/ buyers, sold quick]
Theory of Portfolio Choice
Theory of Portfolio Choicetheory that outlines how much of an asset
people will want to hold in their portfolios, as determined by wealth,
expected returns, risk, and liquidity
Response of the quantity of an asset demanded to changes in:
Variable
Change in Variable
Change in quantity demanded
Wealth
Expected return relative to other assets
Risk relative to other assets
Liquidity relative to other assets
Only increases are show, decreases would make the right column opposite
Supply & Demand in the Bond Market
Negative relationship between bond prices & interest rates:
o When bond prices rise, interest rates fall [AND VISE VERSA]
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Demand CurveCurve depicting the relationship between quantity
demanded and price when all other economic variables are held constant
Demand Curve
1 year discount bond no coupon payments, pay $1,000 face value in a year
o Holding period = 1 yr, return is known absolutely & is = interest rate
measured by yield to maturity [Expected return = interest rate i]
o i = Re = [F-P] /P
I = interest rate = yield to maturity. Re = expected return. F =
FV of discount bond. P = initial purchase price of discount bond
o If bond sells for $950 ($1,000 - $950) / $950 = .053 = 5.3%
Assume quantity of bonds demanded is $100 billion
o At price $900 ($1,000 - $900) / $900 = .111 = 11.1%
Quantity of bonds demanded increases to $200 billion
Lower bond prices (everything else being equal), the quantity demanded is
higher
downward slope
Supply Curve
Supply Curvecurve depicting the relationship between quantity supplied
and price when all other economic variables are held constant
When price of bonds is $750 only $100 billion are supplied
$800 bonds, interest rate is lower [b/c at this interest rate, its less costly
to borrow by issuing bonds, firms more willing to borrow so higher supply]
As price increases (everything else being equal), the quantity supplied increases
upward slope
Market Equilibrium
Market Equilibriumoccurs in an economy when the quantity that people
are willing to buy (demand) is equal to the quantity that people are willing to
sell (supply) at a given price [indicates where market will settle]
o Bond Market Bd = Bs
Equilibrium/Market Clearing Pricewhere quantity demanded equals
quantity supplied
Equilibrium/Market Clearing Interest Rateinterest rate that corresponds
to market clearing price
Excess Supplysituation in which the quantity supplied is greater than the
quantity demanded
o People want to sell more than others want to buy price of bonds
fall until price has reached equilibrium & excess supply eliminated
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