# Asset demand in order to derive a demand curve lets

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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. Once again, we see the inverse relationship between the price of bonds and interest rates. As the price of the bond declines, the yield to maturity of the bond increases. We can use this information to draw a demand curve with two vertical axes, one on the left measuring the price of the bond (P) and one on the right measuring interest rates (i). The price of the bond is measured as usual, increasing as we move up the axis. Interest rates, however, are measured in reverse, so they decrease as we move up the axis. The axes look like this: Figure 6-1 Bond prices and interest rates P i 600 0 400 50 200 200 Q Suppose that the demand for the bond is given by P = 800 – 2Q. Then the demand curve for the discount bond would look like this: Price Yield to maturity 600 0 500 20 400 50 300 100 200 200 100 500 46

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 Figure 6-2 The demand for bonds P i 600 0 400 50 200 B d 200 100 200 300 Q Note that we’ve gone six classes in economics, and this is our first graph! As we would expect, the demand curve is downward-sloping. As the price of a bond decreases, investors want to purchase more of the bond. The interest rate on a simple bond is equal to the return because the bond is only held one period and makes no coupon payments. As the return increases, the theory of asset demand suggests that the quantity demanded of that asset will increase. For an example of a bond demand curve, see the results for the Series A or Series B bond markets. Asset Supply The supply of assets depends on the amount of external financing that is sought by borrowers in the economy. The more that companies want to borrow, the more they will issue stocks and bonds to finance that borrowing. The supply of an asset is 1. positively related to the expected profitability of investment opportunities. 2. positively related to the rate of expected inflation. 3. positively related to government activities such as deficits. Note that all three factors are positively related to supply. 1. If firms believe that investment opportunities are more profitable, then they will be willing to issue more stocks, bonds, and other securities to finance those investment opportunities. 2. If the rate of expected inflation increases, then, ex ante, the Fisher equation (from last class) states that expected real interest rates will fall for a given nominal interest rate. If the anticipated real cost of borrowing declines, then firms will borrow more. 3. If the government runs a budget deficit, then it will need to issue Treasury securities to help finance that deficit. This increases the supply of bonds. 47
Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 Suppose that the supply of our discount bond is given by P = 2Q. The supply curve will look like this: Figure 6-3 The supply of bonds P B s i 600 0 400 50 200 200 100 200 300 Q As expected, the supply curve is upward-sloping. At lower interest rates, firms and governments are willing to borrow more by issuing bonds.

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