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Unformatted text preview: Chapter 4 Why Do Interest Rates Change? Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Summary Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply and Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds Case : Changes in the Equilibrium Interest Rate Due to Expected Inflation: The Fisher Effect Case : Changes in the Interest Rate Due to a Business Cycle Expansion Case: Explaining Low Japanese Interest Rates Case : Reading the Wall Street Journal : The “Credit Markets” Column The Wall Street Journal: Following the News : The “Credit Markets” Column The Practicing Manager: Profiting from Interest-Rate Forecasts The Wall Street Journal: Following the News : Forecasting Interest Rates Appendix 1: Models of Asset Pricing Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Appendix 3: Loanable Funds Framework Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework ¡ Overview and Teaching Tips As is clear in the Preface to the textbook, I believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined, how financial institutions manage their assets and liabilities, why financial innovation takes place, how prices are determined in the stock market and the foreign exchange market. Chapter 4 Why Do Interest Rates Change? 17 One teaching device that I have found helps students develop their intuition is the use of summary tables, such as Table 1, in class. I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout my course and in this book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly. The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market. An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an...
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