Economics of Finance and Banking Chapter 5

shifts in supply of bonds

1. expected profitability of investment opportunities 2. expected inflation 3. government budget

determinants of asset demand

1. wealth 2. expected return 3. risk 4. liquidity

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

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

expected inflation

an increase in the expected inflation causes the supply of bonds to increase and the supply curve to shift to the right

shifts in supply of money

an increase in the money supply engineered by the federal reserve will shift the supply curve for more money to the right

bond risk shift

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 demands for bonds to rise and the demand curve to shift to the right

asset market approach

asset market approach for understanding behavior in financial markets-which emphasizes stock of assets rather than flows in determining asset prices- is the dominant methodology used by economists, because correctly conducting analyses in terms of flows is very tricky, especially when we encounter inflation

liquidity preference framework

determines the equilibrium interest rate in terms of the supply of and demand for money.

shifts in demand for bonds

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

bond expected returns shift

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 demand to decline and the demand curve to shift to the left

government budget

higher government deficits increase the supply of bonds and shifts the supply curve to the right -government surpluses decrease the supply of bonds and shift the supply curve to the left

bond wealth shift

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 demand curve shifts to the left

expected profitability of investment opportunities

in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. -in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shits to the left

bond liquidity shift

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

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. in the bond market this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied

excess supply

quantity of bonds supplied exceeds the quantity of bonds demanded. people want to sell more than others want to buy, the price of the bond will fall.

demand curve

shows the relationship between quantity demanded and the price when all other economic variables are held constant

supply curve

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

theory of asset demand

stats that, holding all of the 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 alliterative assets 3. the quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4. the demand of an asset is positively related to its liquidity relative to alternative assets

opportunity cost

the amount of interest (expected return) sacrificed by not holding the alternative asset

risk

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

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 will be the quantity demanded

expected return

the return expected over the next period on one asset relative to alternative assets an increase in an assets 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 holding everything else constant, an increase in wealth raises the quantity demanded of an asset

shifts in demand for money

two factors cause the demand curve for money to shift: income price level

fisher effect

when expected inflation rises, interest rates will rise

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 remains equal) interest rates will decline

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

excess demand

when the quantity of bonds demanded exceeds the quantity of bonds supplied. people want to buy more bonds than people are willing to sell, so the price of the bonds increase