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Chapter 5

Chapter 5 EC223.docx

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Department
Economics
Course
EC223
Professor
Angela Trimarchi
Semester
Winter

Description
EC223 Chapter 5 – The Behaviour of Interest Rates Week 5 Determinants of Asset Demand -Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1. Wealth – the total resources owned by the individual, including all assets 2. Expected return – the return expected over the next period on one asset relative to alternative assets 3. Risk – the degree of uncertainty associated with the return on one asset relative to alternative assets 4. Liquidity – the ease and speed with which an asset can be turned into cash relative to alternative assets Wealth -Holding everything else constant, an increase in wealth raises the quantity demanded of an asset Expected Return -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 Liquidity -The more liquid an asset it relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded Theory of Asset Demand -States, holding al 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 Market -Each bond price is associated with a particular level of interest rates -The negative relationship between bond prices and interest rates means that when we see that the bond price rises, the interest rate falls -A bond demand curve shows the relationship between the quantity demanded and the price when all other economic variables are held constant Demand Curve -The expected return on this bond is equal to the interest rate -When the expected return on bonds is higher, with all other economic variables held constant, the quantity demanded of bonds will be higher as predicted by the theory of asset demand EC223 Chapter 5 – The Behaviour of Interest Rates Week 5 Supply Curve Shows the relationship between the quantity supplied and the price when all other economic variables are held constant Market Equilibrium -Occurs when the amount that people are willing to buy equals the amount that people are willing to sell -Excess supply – people want to sell more bonds than others want to buy, the price of the bonds will fall -Excess demand – people want to buy more bonds than others are willing to sell, and so the price of bonds will be driven up -The concept of equilibrium price is a useful one because it indicates where the market will settle Supply and Demand Analysis -Because the interest rate that corresponds to each bond price is also marked on the vertical axis, this diagram allows us to read the equilibrium interest rate, giving us a model that describes the determination of interest rates -A supply and demand diagram can be drawn for any type of bond because the interest rate and price of a bond are always negatively related for any type of bond, whether a discount bond or a coupon bond -Supply and demand are always in terms of stocks of assets, not in terms of flows -The asset market approach for understanding behaviour in financial markets – which emphasizes stocks of assets rather than flows in determining asset prices – is now the dominant methodology used by economists because correctly conducting analyses in terms of flows is very tricky, especially when we encounter inflation Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds -Factors that cause demand curves for bonds to shift: -Wealth -Expected returns on bonds relative to alternative assets -Risk of bonds relative to alternative assets -Liquidity of bonds relative to alternative assets -Refer to p. 89 for a physical demonstration if needed Wealth -In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right -In a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left Expected Returns -Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left -Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right -An increase in the expected rate of inflation lowers the expected return for bonds, causing their EC223 Chap
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