ECON330 Chapter 5
If the interest rate on a bond is above the equilibrium interest rate, there is an excess ________ for bonds and the bond price will ________.
demand; rise
What effect will a sudden increase in the volatility of gold prices have on interest rates?
Interest rates will decrease because bonds will become relatively less risky, which increases the demand for bonds
What will happen to interest rates if the public suddenly expects a large increase in stock prices?
Interest rates will rise because the expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds decreases
liquidity preference framework
a model that determines the equilibrium interest rate in terms of the supply and demand for money
How might a sudden increase in people's expectations of future real estate prices affect interest rates?
Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease.
ceteris paribus
all other things being equal
In Keynes's liquidity preference framework,
an excess supply of bonds implies an excess demand for money.
You expect inflation to rise, and gold prices tend to move with the aggregate price level. Are you more or less willing to buy gold?
More willing because expected return increases
Explain the effect that a large federal deficit will have on interest rates.
Supply curve will shift to the right, and cause interest rates in increase
risk effect on the demand curve
an increase in the riskiness of bonds causes the demand to fall and the demand curve to shift to the left
Will there be an effect on interest rates if brokerage commissions on stocks fall?
Yes, interest rates would rise because stocks become more liquid than before, which would reduce the demand for bonds
The interest rate falls when either the demand for bonds ________ or the supply of bonds ________.
increases; decreases
When an economy grows out of a recession, normally the demand for bonds ________ and the supply of bonds ________, everything else held constant.
increases; increases
The demand for gold increases, other things equal, when
interest rates are expected to rise.
Everything else held constant, when stock prices become less volatile, the demand curve for bonds shifts to the ________ and the interest rate ________.
left; rises
In the bond market, the bond demanders are the ________ and the bond suppliers are the ________.
lenders; borrowers
You would be _____ willing to buy a house if you expect housing prices to fall because __________________________.
less, the return on your house will actually be negative
In Keynes's liquidity preference framework, individuals are assumed to hold their wealth in two forms:
money and bonds
You would be _______ willing to buy gold if you expect interest rates to rise because _________________________.
more; now gold has a better expected return than bonds
You would be ________ willing to buy gold if you expect inflation to rise, and gold prices tend to move with the aggregate price level because__________________.
more; the value of gold will offset the rising prices to keep your real value the same
An increase in the expected rate of inflation will ________ the expected return on bonds relative to the that on ________ assets, everything else held constant.
reduce; real
Everything else held constant, during a business cycle expansion, the supply of bonds shifts to the ________ as businesses perceive more profitable investment opportunities, while the demand for bonds shifts to the ________ as a result of the increase in wealth generated by the economic expansion.
right, right
Treasury notes are considered _____________ assets
risk-free
When the federal government sells a Treasury bond in the primary market dash—via Treasury auction, it is:
seeking to finance government spending as an alternative to raising taxes
If there is an excess demand for money, individuals ________ bonds, causing interest rates to ________.
sell; rise
A downward revision of inflation expectations will affect the bond market how?
shifts bond demand to the right, bond supply to the left, raises equilibrium price (bond yield will decrease)
increased money growth temporarily lowers:
short term interest rates (depends critically on how fast people's expectations about inflation adjust)
When the price of a bond is above the equilibrium price, there is an excess ________ bonds and price will ________.
supply of; fall
What change in money supply would cause an increase in interest rates?
shift of supply curve to the left
a large and growing federal deficit will affect the market for government securities how?
shift the supply curve to the right and lower equilibrium price
In a business cycle expansion, the ________ of bonds increases and the ________ curve shifts to the ________ as business investments are expected to be more profitable.
supply; supply; right
"No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquidity than another security." Is this statement true, false, or uncertain?
True because for a risk-averse person, those characteristics make a security less desirable.
What will happen to interest rates if prices in the bond market become more volatile?
When bond prices become more volatile, bonds become riskier and the demand for bonds will fall, which causes interest rates to rise
Would fiscal policy makers ever have reason to worry about potentially inflationary conditions?
Yes, higher inflation leads to a higher debt service burden and increases the costs of financing deficit spending.
excess demand
the quantity demanded at a given point is greater than the quantity supplied
excess supply
the quantity of bonds supplied exceed the quantity of bonds demanded
demand curve
the relationship between the quantity demanded and the price when all other economic variables are held constant
supply curve
the relationship between the quantity supplied and the price ceteris paribus
before deciding to buy an asset, an individual must consider the following factors:
wealth, expected return, risk, liquidity
parameters for shifts in the demand for bond
wealth, expected returns on bonds relative, risk of bonds relative, liquidity of bonds relative
an important observation from supply and demand analysis is
when expected inflation rises, interest rates will rise (the fisher effect)
income effect on interest
when income is rising, holding other variable constant, interest rates will rise
money supply effect on interest rates
when the money supply increases, all else equal, interest rates will decline
If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates?
Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income, price level, and inflation will tend to lower interest rates.
M1 money growth in the U.S. was about 16% in 2008, 7% in 2009, and 9% in 2010. Over the same time period, the yield on 3-month Treasury bills fell from almost 3% to close to 0%. Given these high rates of money growth, why did interest rates fall, rather than increase?
The income, price-level, and expected-inflation effects were small relative to the liquidity effect.
In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for quite some time. Does this make sense?
Yes, the decrease in investment opportunities and known risk factors significantly offset the wealth effect on demand and the deficit effect on supply.
You expect interest rates to rise. More or less willing to buy gold?
You would be more willing because the expected return on gold has risen relative to the expected return on long-term bonds, which has declined.
Using the numbers 1, 2, 3, and 4, rank the following four assets from most liquid (1) to least liquid (4).
a 10,000-square-foot office - 4 $2,000 in cash - 1 a $10,000 treasury bill - 2 100 shares of google stock - 3
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 (increase in money supply is a rise in interest rate in response to higher income)
price level effect
a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right (increase in the money supply raises interest rates in response to rise in price level)
When the interest rate on a bond is ________ the equilibrium interest rate, in the bond market there is excess ________ and the interest rate will ________.
above; demand; fall
Factors that can cause the supply curve for bonds to shift to the right include
an expansion in overall economic activity.
expected return effect
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
inflation effect on the supply curve
an increase in inflation causes the supply of bonds to increase and the supply curve to shift to the right
supply of money effect (expected inflation)
an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right (increase in money supply causes rise in interest rates in response to rise in expected inflation rate)
wealth effect
an increase in wealth raises the quantity demanded of an asset
expected profitability effect on the supply curve
as expected profitability increases, the supply of bonds increases and the supply curve shifts to the right
the first step in the analysis of a portfolio is to obtain a
bond demand curve
A movement along the bond demand or supply curve occurs when ________ changes.
bond price
If the price of gold becomes less volatile, then, other things equal, the demand for stocks will ________ and the demand for antiques will ________.
decrease; decrease
When the economy slips into a recession, normally the demand for bonds ________, the supply of bonds ________, and the interest rate ________, everything else held constant.
decreases; decreases; falls
Holding everything else constant, if interest rates are expected to increase, the demand for bonds ________ and the demand curve shifts ________.
decreases; left
how does growth in GDP affect market framework for money?
demand curve for money shifts to the right, equilibrium price rises
If stock prices are expected to climb next year, everything else held constant, the ________ curve for bonds shifts ________ and the interest rate ________.
demand; left; rises
In the figure above, a factor that could cause the demand for bonds to shift to the right is:
expectations of lower interest rates in the future
parameters for shifts in the supply curve
expected profitability of investments, expected inflation, government budget deficits
Everything else held constant, an increase in the riskiness of bonds relative to alternative assets causes the demand for bonds to ________ and the demand curve to shift to the ________.
fall; left
The reduction of brokerage commissions for trading common stocks that occurred in 1975 caused the demand for bonds to ________ and the demand curve to shift to the ________.
fall; left
Everything else held constant, if the expected return on RST stock declines from 12 to 9 percent and the expected return on XYZ stock declines from 8 to 7 percent, then the expected return of holding RST stock ________ relative to XYZ stock and demand for XYZ stock ________.
falls; rises
opportunity cost
foregone interest earnings by holding wealth in the form of cash
government budget deficits effect on the supply curve
higher government deficits increase the supply of bonds and shift the supply curve to the right
return effect on the demand curve
higher interest rates lower expected return, decrease the demand, and shift the demand curve to the left
risk effect
holding everything else constant, if an asset's risk rises relative to that of alternative assets, its quantity demanded will fall
shifts in the demand curve for money are caused by two factors
income and price level
An increase in demand will cause the difference between short-term and long-term bond yields to ________.
increase
Interest rates _________ when the economy is expanding (pro cyclical)
increase
growing deficits will cause interest rates to ______________
increase
liquidity effect on the demand curve
increased liquidity results in increased demand for bonds and the demand curve shifts to the right
If the expected return on bonds increases, all else equal, the demand for bonds increases, the price of bonds ________, and the interest rate ________.
increases; decreases
theory of portfolio choice
tells us how much of an asset people want to hold in their portfolio (holding all other factors constant: 1. demand is positively related to wealth 2. demand is positively related to expected return relative to alternatives 3. demand is negatively related to risk of returns relative to alternatives 4. demand is positively related to liquidity relative to alternative assets
opportunity cost
the amount of interest sacrificed by not holding the alternative asset
market equilibrium (market clearing price)
the amount that people are willing to buy equals the amount that people are willing to sell at a given price
Everything else held constant, when real estate prices are expected to decrease
the demand curve for bonds shifts to the right and the interest rate falls.
asset market approach
the dominant methodology used by economists for understanding behavior in financial markets
liquidity effect
the more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded
price level effect on interest rates
when the price level increases, the supply of money and other economic variables constant, interest rates will rise
wealth effect on the demand curve
when wealth rises, the demand for bonds rises and the curve shifts to the right