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CHAPTER 5 - THE BEHAVIOR OF INTEREST RATES Nominal interest rates for 3 month Tbills were 1% in the early 50s, reached 15% in 1981, fell to 3% in 1993 and rose to 5% in 1995, and are now about 6% (See page 88). What explains these interest rate movements? Since nominal interest rate movements are negatively related to bond prices, understanding interest rate changes also helps us understand movements in bond prices. We can either look at the Supply and Demand for Credit to understand interest rate changes or the Supply and Demand for Bonds to understand bond price changes. We can also look at the Supply and Demand for Money to understand interest rates. That is, we look at economic conditions and market forces (S and D) in the credit market, bond market, money market to get an understanding of the behavior of interest rates over time. We start by looking at the Theory of Asset Demand, since bonds and money are assets, and understanding what affects bond demand and money demand allows us to understand market equilibrium and changes in equilibrium interest rates. Micro (Price Theory) vs. Macro (Interest Rate Theory). We assume in this chapter that there is a single interest rate in the economy to simplify the analysis, in CH 6 we investigate why interest rates vary for different securities. Theory of Asset Demand addresses the issue of which assets to buy and which assets to combine in a portfolio. Example: assume that you just won the lottery or got a large inheritance. How you decide to invest is the Theory of Asset Demand or the Theory of Portfolio Choice. And since money is a financial asset (M2), we need to study money in the context of assets and financial markets. An asset is any property or security that is used as a store of value, allowing us to transfer our current wealth into purchasing power in the future. What determines Asset Demand? Four factors: 1. Wealth. An increase in wealth raises the demand for an asset, ceteris paribus. Responsiveness of demand to changes in wealth. Two types of assets: i. Normal assets - necessities (elasticity is between 0 and 1) Currency and checking accounts. ii. Luxury assets - elasticity greater than one. Stocks and bonds Example: you are very wealthy to start with and your wealth goes up by 10%, you increase your holdings of stocks and municipal bonds by 20% and increase your holdings of cash and checking accounts by less than 10%. 2. Expected returns - an increase (decrease) in an asset's expected return, relative to alternative assets, increases (decreases) the demand for the asset, ceteris paribus. Example: A company's earnings forecast improves (declines), demand for the stock will increase (decrease), resulting in a higher (lower) price.
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3. Risk - if an asset's risk increases (decreases), relative to other assets, the demand will fall (rise). Assumes investors are risk-averse. Example: a company's credit rating is downgraded (from AAA to C), demand for its bonds will fall, price will fall. 4. Liquidity
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This note was uploaded on 11/18/2011 for the course ECON 210 taught by Professor Blare during the Fall '10 term at Rutgers.

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