ECON 310 Chapter 5: Chapter 5 Notes
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Department
Economics
Course Code
ECON 310
Professor
Chad Hogan

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Chapter 5 Notes: The Behavior of Interest Rates PREVIEW - What explains these substantial fluctuations in interest rates? - How overall level of nominal interest rates is determined and which factors influence their behavior. - Interest rates are negatively related to the price of the bonds - Understanding why bond prices change show us why interest rates fluctuate - Portfolio theory - an economic theory that outlines criteria that are important when deciding how much of an asset to buy - Market Equilibrium - the point at which the quantity of supplied equals the quantity demanded - Changes in equilibrium interest rates DETERMINANTS OF ASSET DEMAND What determines the quantity demanded of an asset - Factors determining whether to buy and hold an asset over another 1. Wealth - the total resources owned by an 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 - We have more resources available to buy with 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 - Either the asset itself becomes more profitable or the competing assets become less profitable (lower returns) RISK - The degree of risk or uncertainty of an asset’s returns also affects demand for the asset - Risk averse - prefers the option with less risk, regardless of the same expected return - Risk preferer/risk lover - a person who prefers risk - Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall LIQUIDITY - Liquidity - how quickly an asset be converted into cash at low costs - The market has many buyers and sellers - The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is and the greater the quantity demanded will be THEORY OF PORTFOLIO CHOICE - Theory of Portfolio Choice - how much of an asset people will want to hold in their portfolios 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 is negatively related to the risk of its returns relative to alternative assets a. The higher the risk (variable), the lower the demand 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 bonds is associated with a particular level of the interest rate - The interest rate falls when the price rises - Demand Curve - the relationship between the quantity demanded and the price when all other economic variables are held constant - Ceteris paribus - other things being equal in Latin DEMAND CURVE - If the holding period is one year, then the return on the bonds is known absolutely and is equal to the interest rate as measured by the yield to maturity - The expected return on this bond is equal to the interest rate: 𝑖 𝑖−𝑖 - 𝑖 = 𝑖 = 𝑖 - I - interest rate = YTM - R^e - expected return - F - face value of the discount bond - P - initial purchase price of the discount bond - With excess supply, the bond price falls to P* - With excess demand, the bond price rises to P* SUPPLY CURVE - Supply curve - the relationship between the quantity supplied and the price when all other economic variables are held constant - The supply increases with the price because it is less costly to borrow issuing bonds, so the firms will be more willing to borrow more through bond issues MARKET EQUILIBRIUM - Market equilibrium - the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price - Bond market: B^d=B^s - The demand and the supply curves intersect at a bond price or quantity demanded = quantity supplied - Equilibrium or market-clearing price - Excess supply - a condition in which the quantity of bonds supplied exceeds the quantity of bonds demanded - The price falls because more people want to buy rather than sell bonds - Excess demand - there is greater demand than available supply, so people are willing to pay more for the bonds - The equilibrium price indicates where the market will settle SUPPLY AND DEMAND ANALYSIS - Supply and demand are always described in terms of stocks (amounts at a given point in time) of assets, not in terms of flows - Asset market approach – emphasizes stocks of assets, rather than flows, in determining asset prices - Flow analysis is difficult CHANGES IN EQUILIBRIUM INTEREST RATES - Movements along the curve – quantity demanded/supplied changes as a result of a change in the price of the bond/interest rate - Shifts in the curves – the quantity demanded/supplied changes at each given price/interest rate of the bond in response to a change in some other factor besides the bond’s price or interest rate - New equilibrium price SHIFTS IN THE DEMAND FOR BONDS Demand changes based on these four parameters: 1. Wealth 2. Expected returns on bonds relative to alternative assets 3. Risk of bonds relative to alternative assets 4. Liquidity of bonds relative to alternative assets WEALTH - Business cycle expansion – the economy is growing rapidly and wealth is increasing, the quantity of bonds demanded at each bond price/interest rate increases - 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 - Also, the public’s propensity to save affects the demand curve - More saving = more wealth = more demand for bonds EXPECTED RETURNS - Higher expected future interest rates lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left - Lower expected future interest rates increase the demand for long-term bonds and shift the demand curve to the right - This is because they foresee the long-term prices rising for the bonds - An increase in expected return on alternative assets lowers the demand for bonds and shifts the demand curve to the left - People wo
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