Chapter 5

Shifts in the SUpply of Bonds

1. Expected profitability of investment oppurtunities 2. Expected inflation 3. Government budget deficits

Shifts in the Demand for Money

1. Income Effect 2. Price Level Effect

Determinants of Asset Demand

1. Wealth 2. Expected Return 3. Risk 4. Liquidity

Shift in the Demands for Bonds

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.

Excess Demand

A situation in which the quantity demanded is greater than the quantity supplied

Expected profitability of investment

Therefore, in a business cycle expansion, the supply of bonds increases and the supply of bonds increases and the supply curve shifts to the right. Likewise, in a recession, when far fewer profitable investment oppurtunities are expected, the supply of bonds falls and the supply curve shifts to the left.

Liquidity

Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right. Similarly, increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left

Fisher Effect

Named after Irving Fisher that states when inflation rises, interest rates will rise. Many economists recomment that inflation must be kept low if we want to keep nominal interest rates low.

Market Equilibrium

Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (Supply) at a given price.

Demand Curve

Shows the relationship between the quantity demanded and the price when all other economic variables are held constant. Interest Rate=Expected Return= (Face Value of the Discount Bond-Initial Purchase Price of the Discount Bond)/Initial Purchase price

Supply Curve

Shows the relationship between the quantity supplied and the price when all other economic variables are held constant

Risk

The degree of uncertainty associated with the return on one asset relative to alternative assets. Holding everything else constant, if an asset's risk rises relative to that of alternative assets, its quantity demanded will fall.

Excess Supply

situation in which the quantity supplied is greater than the quantity demanded.

Theory of Portfolio Choice

This list tells us how much of an asset people will want to hold in their portfolios. Holding all 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 asset.

Changes in Income

When income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise.

Changes in Money Supply

When the money supply increases (Everything else remaining equal), interest rates will decline

Income Effect

A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Liquidity Preference Framework

A model for determining the equilibrium interest rate, developed by John Maynard Keynes. This framework determines the equilibrium interest rate in terms of the supply of and demand for money rather than the supply of and demand for bonds.

Price-Level Effect

A rise in the price level causes the demand for money at each interest rate increase and the demand curve to shift to the right.

Expected Inflation

An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right and a decrease in expected inflation causes the supply of bonds to decrease and the supply curve to shift to the left.

Shifts in the Supply of Money

An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right

Asset Market Approach

Emphasizes stocks of assets, rather than flows, in determining asset prices. It is the dominant methodology used by economists, because correctly conducting analyses in terms of flows is very tricky, especially when we encounter inflation

Government Budget Deficits

Higher government deficits increase the supply of bonds and shift the supply curve to the right. On the other hand, government surpluses, as occured in the late 1990's, decrease the supply of bonds and shift the supply curve to the left.

Expected inflation Effect

The expected inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rates.

Risk

An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right.

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-termbonds and shift the demand curve to the right. An increase in expected return on alternative assets lowers the demand for bonds and shifts the demand curve to the left. An increase in the expected rate of inflation lowers the expected returns on bonds, causing theri demand to decline and the demand curve to shift to the left.

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.

Oppurtunity Cost

The amount of interest (expected return) sacrificed by not holding the alternative asset, in this case a bond. As the interest rate on bonds, i, rises, the oppurtunity cost of holding money rises, thus money is less desirable and the quantity of money demanded falls.

Liquidity

The ease and speed with which an asset can be turned into cash relative to alternative assets. 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.

Income Effect

The income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income

Price Level Effect

The price level effect from an increase in the money supply is a rise in interest rates in response to the rise in price level

Expected Return

The return expected over the next period on one asset relative alternative assets. 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.

Wealth

The total resources owned by the individual, including all assets. Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.

Changes in the Price Level

When the price level increases, with the supply of money and other economic variables held constant, interest rates will rise.