Money and Banking - Mid term 2 (ch. 5)

suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations.

If many big corporations decide not to issue bonds because of new financial markets regulations, this will affect the supply curve. The impact will translate into a shift to the left in the supply curve, increasing bond's prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.

theory of portfolio choice

a theory that outlines how much of an asset people will want to hold in their portfolios, as determined by wealth, expected returns, risk, and liquidity all relative to other assets.

we expect that return will _____ if interest rates______ in the future (this may happen half the time)

decrease, increase

liquidity of alternative assets increases

demand curve shifts to the left (e.g. 1975: brokerage commissions reduced for trading common stocks)

liquidity of bonds increases

demand curve shifts to the right

If wealth increases

demand for bonds at each bond price (or at each interest rate) rises - business cycle expansion - propensity to save

business cycle recession

expected profitability of investment opportunities decreases, supply of bonds decreases (supply curve shifts to the left)

business cycle expansion

expected profitability of investments increases, supply of bonds increases (supply curve shifts to the right)

expected future interest rates increase

expected return on bonds decreases, demand for bonds decreases (demand curve shifts to the left)

government expenditures is higher than its revenues

leads to government deficits, US Treasury issues bonds to finance gov. deficits, supply of bonds increases (supply curve shifts to the right)

government expenditures is less than its revenues

leads to government surplus, supply of bonds decreases (supply curve shifts to the left)

An increase in an asset's expected return relative to that of an alternative asset, holding everything else constant, ________ the quantity demanded of the asset.

raises

Fisher effect formula

real interest rate = nominal interest rate - inflation rate nominal interest rate = real interest rate + inflation rate

when expected inflation rises (in relation to demand for bonds)

real interest rate decreases, expected return on bonds decreases, demand for bonds decreases (demand curve shifts to the left)

expected inflation increases

real interest rate decreases, real cost of borrowing decreases, issues more bonds, supply of bonds increases (supply curve shifts to the right)

when expected inflation (in relation to borrowing and supply)

real interest rate decreases, real cost of borrowing decreases, issuing more bonds, supply of bonds increases (supply curve shifts to the left)

if interest rate when you sell the bond is higher than the interest rate when you buy the bond

the price at which you sell the bond is lower than the price at which you buy the bond.

if you expect that interest rate will rise in the future

then you also expect that return on bonds will fall; hence, you demand less bonds today.

interest rates and inflation rates

have and inverse relationship

liquidity

how quickly an asset can be converted into cash at a low transaction cost - an asset is liquid if the market in which it is traded has many buyers and sellers

interest rates tend to (rise/fall) during business cycle expansion and (rise/fall) during recessions (pro-cyclical)

rise; fall

the more liquid an asset is relative to alternative assets

the more desirable it is and the greater the quantity demanded will be

if wealth decreases

demand for bonds at each price (or at each interest rate) decreases - business cycle recession - decreased propensity to save

Bd < Bs

excess supply, price will fall and interest rate will rise

suppose that people decide to permanently increase their savings rate.

more savings will lead to an increase in wealth and a higher demand for bonds. This will create a shift to the right in the demand curve, therefore decreasing interest rates.

interest rate is (negatively/positively) related to the bond price?

negatively

Changes in factors that affect how many bonds corporations or the gov. will want to issue that will make the supply curve shift:

- expected profitability of investment opportunities - expected inflation - government budget deficits

Whether to buy and hold an asset rather than another depends on:

- wealth - expected return - risk - liquidity

depending on if supply curve shifts more than the demand curve, the new interest rate can either:

rise or fall; interest rates in business cycle expansion are ambiguous.

In the aftermath of the global nancial crisis, in Europe and the United States, as well as in Japan, ination has fallen to very low levels, sometimes even going negative, same as the expected ination; at the same time, all of these countries have been experiencing a lack of protable investment opportunities. Explain graphically why interest rates are low.

Expected inflation decrease -> rightward shift of the demand curve and leftward shift of the supply curve. profitable investment opportunities decreases -> supply curve shifts to the left again.

If there is a sudden increase in people's expectations of future relationships estate prices.

Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve Bd shifts to the left, and the equilibrium bond price falls, so the interest rate rises.

Fisher effect

an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged (expected inflation and the interest rate generally move together)

net result: when expected inflation rises

bond price falls and interest rates rise (but quantity of bonds can either rise, fall or remain the same)

Bd = Bs

defines the equilibrium (or market clearing) price and interest rate

bonds increase as...

inflation increases

interest rate risk

is interest rate rises in the future, bond prices fall, capital loss, rate of return falls

If an asset's risk rises (relative of that of alternative assets)

its quantity demanded will fall

an increase in the volatility of prices in another asset market (e.g. stock market)

riskiness of alternative asset increases, demand for bonds increases (demand curve shifts to the right)

Prices in the bond market become more volatile

riskiness of bonds increases, demand for bonds decreases (demand curve shifts to the left)

expected inflation decreases

supply of bonds decreases (supply curve shifts to the left)

If brokerage commissions on stocks fall.

the fall in brokerage commissions makes stocks more attractive than bonds. As a result, the demand for bonds declines, and interest rates increase.

wealth

the total resources owned by the individual, including all assets - an increase in wealth raises the quantity demanded of an asset

Bd > Bs

there is excess demand, price will rise and interest rate will fall