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Class 6 - Econ 350 U.S Financial Systems Markets and...

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 Econ 350 U.S. Financial Systems, Markets, and Institutions Class 6: Interest rates – Theory of asset demand In today’s class, we will seek to understand the mechanics of securities markets. Starting with a security such as a bond, what factors determine the demand for that asset? What factors determine the supply of an asset? Once we gain a grasp of securities markets, we can begin to comprehend the determinants of bond prices and interest rates. We finish by exploring two models of interest rate determination, the loanable funds model (sometimes called the classical model) and the Keynesian model of liquidity preference. Both yield similar results because they are concerned with different sides of the same coin. Class Objectives After today’s class, you should; -- know the determinants of the demand for assets. -- know the determinants of the supply of assets. -- understand the connections between the bond market and the loanable funds market. -- be able to show the effects of changes in money supply or money demand in the Keynesian liquidity preference model. The Theory of Asset Demand In general, there are many factors that determine how much of an asset investors will want to purchase. These concern the characteristics of the investors, the asset, and other assets. In general, we can develop the following theory of asset demand: The demand for an asset is 1. positively related to wealth. 2. positively related to its expected return relative to other assets. 3. negatively related to risk relative to other assets. 4. positively related to its liquidity relative to other assets. Let’s look at each briefly in turn: 1. Obviously, increases in wealth will lead to an increase in the demand for assets. As household wealth increases, households can afford to devote more of their financial wealth to purchasing financial assets. 2. If the expected return of an asset increases, or if the expected return on other assets decreases, then the demand for an asset will increase. Assume, for example, that you can purchase paintings or corporate bonds. If the expected return on corporate bonds declines, say due to corporate accounting scandals, then the demand for paintings will increase and the demand for corporate bonds will fall. 3. If the riskiness of an asset increases, then the demand for that asset will decline and the demand for other assets will increase. Risk is often measured by the standard deviation of the distribution of possible returns. 4. An increase in the liquidity of an asset will lead to an increase in the demand for that asset. By increasing liquidity, secondary markets help to increase the demand for assets in primary markets. 40
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 Asset Demand In order to derive a demand curve, let’s examine a particular asset. A discount bond with a face value of $600, maturing in one year, will have the following yields to maturity based on the price of the bond: Recall that the equation for the yield to maturity for a discount bond is i = (F – P)/P.
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