Chapter 5

Chapter 5 - Determining the Quantity Demanded of an Asset o...

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Unformatted text preview: 8/26/2010 Determining the Quantity Demanded of an Asset o Wealth: the total resources owned by the individual, including ali assets as went/tat; so dag o ngpected Return: the return expected over the next Pym; 33, period on one asset relative to alternative assets titer J . . . . a \i A z»~.t.~\2...cx.mx ‘ o “RISK; the degree of uncertainty assooated With thee game-sat A {i ‘31?” return on one asset relative to alternative assets til“! "53“ 5;” " - gtiquidityk: the ease and speed with which an asset can be turned into cash relative to alternative assets Theory of Asset Demand Holding all 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 alternative assets 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets \Nemim’m "'3‘, i3 e ‘ '/\‘ 2 /i~ , D l Qiéié /l\ , DQ; ‘ A Liagusd ’T‘, D \ Summary Tabfe 1 Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity 8/26/2010 Supply and Demand for Bonds 0 At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship 0 At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship ;\r‘flf‘i§ :fiffigiy‘fi Emu-{WVMME'S F153: "- ‘- ‘ "’ inn—4' -= «.J-z", .x= ‘2? ;:;::C;2" *6ng aigwil) viii; ’x; _ FIGURE 1 Supply and Demand for Bonds Price of Bonds, P (5) moo ;— (i= 0%) (renew: i a 8005— [i=25,o%)! 100 200 309 490 £50 Quantity of Bonds, 3 r, w .; -n:r.._‘-:=%‘:"\ (Sblliions) Egsfififiaf nigh U x! ff‘ .‘ s a. ‘ =.‘i ‘ W .. “wifu r 1:7 37 as D w “0* who w in”? - * s g\_ m _ _ . _‘ N.) imitate {r L =7 —Sx;i’€?iUS -:: Q3 egg} SJ 3 \ 'i-i M o '3'“ > “i 'r *3 7. awn. \7 d. ' 8/26/2010 affix, if: I? .i 4 {:7 V, Fm Market Equilibrium o Occurs when the amount that people are willing to buy (demand) equals the amount that peopie are wiiiing to sell (supply) at a given price - 0 Bd = Bsdefines the equilibrium (or market clearing)" price and interest rate. 0 When Bd > 85 , there is excess demand, price will rise and interest rate will fall 0 When Bd < B5 , there is excess supply, price will fall and interest rate will rise Shifts in the Demand for Bonds 0 Weaith: in an expansion with growing wealth, the demand curve for bonds shifts to the right 0 Expected Returns: higher expected interest rates in the'future lower the expected return for long-term bonds, shifting the demand curve to the ieft 0 Expected Inflation: an increase in the expected rate of inflations iowers the expected return for bonds, causing the demand curve to shift to the left 0 Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left ' 0 Liquidity: increased liquidity of bonds results in the demand curve shifting right 8/26/2010 Summary Table 2 Factors That Shift the Demand Curve for Bonds FIGURE 2 Shift in the Demand Curve for Bonds Price of Bonds, P Quantity of Bonds, 8 Shifts in the Supply of Bonds - Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right 0 Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right 0 Government budget: increased budget deficits shift the supply curve to the right Summary Table 3 Factors That Shift the Supply of Bonds 8/26/20“) 8/26/2010 FIGURE 3 Shift in the Supply Curve for Bonds Price of Bonds, P Quamiiy of Bonds, 8 FIGURE 4 Response to a Change in Expected Inflation Price of Bonds, P Quantity of Bonds. 8 FIGURE 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953—2008 Annual Rate (as) 20 1955 $960 1965 19713 $975 1980 1985 1990 1995 2000 2005 2010 Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical investigation," Carnegie-Rochester Conference Series on Public Policy 15 {1981): 151—200. These procedures involve estimating expected inflation as a function of past interest rates. inflation, and time trends. FIGURE 6 Response to a Business Cycle Expansion Pn'ce of Bonds, P Quantity of Bonds, B 8/26/2010 FIGURE 7 Business Cycle and Interest Rates (Three—Month Treasury Bills), 1951—2008 inleresi Hate M) 1 8 1 5 1 4 1 2 10 8 B 4 2 D m x 2;, mi . ,t ., . . 1950 1955 1960 1955 1970 1975 1988 1935 1990 1995 200—3 2065 2130 Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm. The Liquidity Preference Framework Keynesian model that determines the equilibrium interest rate in terms of the supply of and demand for money. There are two main categories of assets that people use to store their wealth: money and bonds. Total wealth in the economy = B5 + M5 = B‘i + Md Rearranging: 85- Bd = M5 - Md If the market for money is in equilibrium (MS 2 Md), then the bond market is also in equilibrium (B5 = Bd). 8/26/2010 8/26/2010 FIGURE 8 Equilibrium in the Market for Money Interest Rate. 1' 0 mo 200 so 400 500 600 Quantity of Money. M (3 biifions) Demand for Money in the Liquidity Preference Framework 0 As the interest rate increases: li‘a. 5.} — The opportunity cost of holding money ! increases... — The relative expected return of money decreases... o ...and therefore the quantity demanded of money decreases. 10 Shifts in the Demand for Money 0 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 0 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 Shifts in the Supply of Money 0 Assume that the supply of money is controlled by the central bank a An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right 8/26/2010 11 8/26/2010 FIGURE 9 Response to a Change in Income or the Price Level Inierest Rene, i [ MS I Quantity of Money, M FIGURE 16 Response to a Change in the Money Supply interest Rate, 1' Quantiiy of Money, M 12 Summary Table 4 Factors That Shift the Demand for and Supply of Money Everything Else Remaining Equal? e Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates: the liquidity effect. - Income effect finds interest rates rising because increasing the money sUppIy is an expansionary influence on the economy (the demand curve shifts to the right). 8/26/2010 13 8/26/2010 Everything Else Remaining Equal? o Price—Level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price ievel (the demand curve shifts to the right). - Expected-Inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (the demand curve shifts to the right). Price-Level Effect and Expected—Inflation Effect - A one time increase in the money supply will cause prices to rise to a permanently higher ievel by the end of the year. The interest rate wiii rise via the increased prices. 0 Price—level effect remains even after prices have stopped rising. - A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero. - Expected—inflation effect persists only as long as the price ievei continues to rise. 14 FIGURE 11 Response over Time to an Increase in Money Supply Growth “Miami! rammed; FIGURE 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950—2008 Mane}! 9'11""?! Grown": Hafiz { } {deems/1a! ram} 32 as 3D 25 28 213 R :: 29 1:5 22 la 3% 2 o . ._ _, 12 15 : j ' ' F 10 4 V I I I? ; 2 0 MAM , ,3 .4 "2 ms: -3 _$ ~12 8 19501955 1960 1955 L970 1975 l980 1985 1990 S395 2960 2095 2015 Sources: Federal Reserve: www.fecleralreserve.gov/releases/h6/hist/h6hist1.txt. 8/26/2010 35 ...
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Chapter 5 - Determining the Quantity Demanded of an Asset o...

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