Chapter 05 - 5. The Behaviour of Interest Rates 5.1...

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5. The Behaviour of Interest Rates 5.1 Determination of Asset Demand 5.2 Supply and Demand in the Bond Market 5.3 Changes in Equilibrium Interest Rates (Bond M 5.4 Supply and Demand in the Market for Money: 5.5 Changes in Equilibrium Interest Rates (Money
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5.1 2 An asset is a piece of property that is a store of value , an individual must consider four factors when choosing whether to buy and hold an asset: (i) wealth – the total resources owned by the individual, including all assets; (ii) expected return on one asset relative to alternative assets; (iii) risk on one asset relative to alternative assets; and (iv) liquidity relative to alternative assets (i) when an individual’s wealth has increased , more resources will be available with which to purchase assets, the quantity of assets demand increases . Holding everything else constant, an increase in wealth raises the quantity demanded of an asset
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5.1 3 (ii) the return on an asset measures how much an investor gains from holding that asset. When anyone makes a decision to buy an asset, investors are influenced by what they expect the return on that asset to be. 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 ( Figure 5.1 ) (iii) a risk-averse person prefers assets with less risk even though they have the same expected return . Most people are risk-averse, especially in their financial decisions. If an asset’s risk rises relative to that of alternative assets , ceteris paribus,, its quantity demanded will fall ( Figure 5.2 )
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5.1 4 (iv) an asset is liquid if the market in which it is traded has depth and breath (if the market has many buyers and sellers). 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 Holding all of the other factors constant, the theory of asset demand states (i) the quantity demanded of an asset is positively related to wealth
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5.1 5 (ii) the quantity demanded of an asset is positively related to its expected return relative to alternative assets (iii) the quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets (iv) the quantity demanded of an asset is positively related to its liquidity relative to alternative assets
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5.2 6 Bond demand curve – the relationship between the quantity demanded and the price when all other economic variables are held constant For one-year discount bonds with holding period of one year , the return on the bonds is known absolutely and is equal to the interest rate as measured by the yield to maturity , i=RET e =(F-P)/P
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5.2 7 The demand for bond diagram has two vertical axes with bond price and interest rate moving the opposite direction ( Figure 5.3 ), when bond price falls , the expected return rises and quantity demanded of bonds will be higher (ceteris paribus) as predicted by the theory of asset demand. The demand curve for bonds ( B d
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Chapter 05 - 5. The Behaviour of Interest Rates 5.1...

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