Chapter 5
Theory of Asset Demand
Chapter 5
Asset:
Factors that affect asset demand:
The Behavior of Interest Rates
Summary Table 1 Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity
Example: Compare the risk and expected return of the three assets.
At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship. At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship.
Wealth: the total resources owned by the individual, including all assets. Expected return (relative to alternative asset) Risk: the degree of uncertainty associated with the return on one asset (relative to alternative asset) Liquidity: the ease and speed with which an asset can be turned into cash (relative to alternative asset)
Risk and Expected Return
Supply and Demand for Bonds
Properties that are stores of value Examples: money, bonds, stocks, art, land, houses, etc.
10% fixed return. 50-50 chance of 20% vs. 0% return. 50-50 chance of 100% vs. -80% return.
Exercise: 1, 2, 3.
Market Equilibrium
Bd = Bs defines the equilibrium (or market clearing) price and interest rate.
When Bd > Bs , there is excess demand, price will rise and interest rate will fall
When Bd < Bs , there is excess supply, price will fall and interest rate will rise
Shifts in the Demand for Bonds
Wealth: higher wealth, higher demand.
Expected Returns:
Wealth is affected by business cycles and the public’s MPS. Higher expected return on bonds, higher demand. Higher expected interest rates in the future lower the expected return for long-term bonds. Higher expected rate of inflations lowers the expected return for bonds, lower demand for bonds.
Table 2 Factors That Shift the Demand Curve for Bonds
Risk: higher risk, lower demand. Liquidity: higher liquidity, higher demand.
Demand for bonds increases, the demand curve shifts to the right.
Shifts in the Supply of Bonds
Expected profitability of investment opportunities:
Factors That Shift the Supply of Bonds
In expansions, the supply increases. In recessions, the supply decreases.
Expected inflation: an increase in expected inflation lowers the cost of borrowing, supply increases. Government budget: increased budget deficits increases supply.
With higher supply, supply curve shifts to the right.
FIGURE 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2008
Example: Fisher Effect Response to higher expected Inflation
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.
Example: Response to a Business Cycle Expansion
FIGURE 7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2008
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
The Liquidity Preference Framework
Money Market
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 = Bs + M s = Bd + M d s
d
s
Rearranging: B - B = M - M
As the interest rate increases:
d
If the market for money is in equilibrium (M s = M d ), s
d
then the bond market is also in equilibrium (B = B ).
The opportunity cost of holding money increases… The relative expected return of money decreases… the quantity demanded of money decreases.
Money supply is set by the Fed.
Shifts in the Demand and Supply of Money
Example: Response to a Change in Income or the Price Level
Demand for money shifts when
Income Effect: Higher income, higher demand for money.
Price-Level Effect: Higher price level, higher demand for money.
Supply for money shifts when the Federal Reserve increases money supply.
Example: Response to a Change in the Money Supply
Table 4 Factors That Shift the Demand for and Supply of Money
Application: Change in Money Supply and Interest Rate
Application: Change in Money Supply and Interest Rate
The liquidity effect: immediate
Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates.
Income effect: slow
Increasing the money supply is an expansionary influence on the economy (the demand curve shifts to the right), interest rates rises.
Price-Level effect: slow
An increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right).
Expected-Inflation effect: slow or quick
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), interest rate rises.
Expected-inflation effect persists only as long as the price level continues to rise.
Liquidity vs. Other Effects
FIGURE 11 Response over Time to an Increase in Money Supply Growth
In Friedman’s view, whether interest rate increases or decreases when money supply increases depends on:
The level of liquidity and other effects.
How fast people’s expectations for inflation adjusts.
FIGURE 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2008
Exercises
No strong support for any of the three scenarios. Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
6, 8, 11, 13, 15.
Chapter 5
Asset:
Factors that affect asset demand:
The Behavior of Interest Rates
Summary Table 1 Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity
Example: Compare the risk and expected return of the three assets.
At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship. At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship.
Wealth: the total resources owned by the individual, including all assets. Expected return (relative to alternative asset) Risk: the degree of uncertainty associated with the return on one asset (relative to alternative asset) Liquidity: the ease and speed with which an asset can be turned into cash (relative to alternative asset)
Risk and Expected Return
Supply and Demand for Bonds
Properties that are stores of value Examples: money, bonds, stocks, art, land, houses, etc.
10% fixed return. 50-50 chance of 20% vs. 0% return. 50-50 chance of 100% vs. -80% return.
Exercise: 1, 2, 3.
Market Equilibrium
Bd = Bs defines the equilibrium (or market clearing) price and interest rate.
When Bd > Bs , there is excess demand, price will rise and interest rate will fall
When Bd < Bs , there is excess supply, price will fall and interest rate will rise
Shifts in the Demand for Bonds
Wealth: higher wealth, higher demand.
Expected Returns:
Wealth is affected by business cycles and the public’s MPS. Higher expected return on bonds, higher demand. Higher expected interest rates in the future lower the expected return for long-term bonds. Higher expected rate of inflations lowers the expected return for bonds, lower demand for bonds.
Table 2 Factors That Shift the Demand Curve for Bonds
Risk: higher risk, lower demand. Liquidity: higher liquidity, higher demand.
Demand for bonds increases, the demand curve shifts to the right.
Shifts in the Supply of Bonds
Expected profitability of investment opportunities:
Factors That Shift the Supply of Bonds
In expansions, the supply increases. In recessions, the supply decreases.
Expected inflation: an increase in expected inflation lowers the cost of borrowing, supply increases. Government budget: increased budget deficits increases supply.
With higher supply, supply curve shifts to the right.
FIGURE 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2008
Example: Fisher Effect Response to higher expected Inflation
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.
Example: Response to a Business Cycle Expansion
FIGURE 7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2008
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
The Liquidity Preference Framework
Money Market
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 = Bs + M s = Bd + M d s
d
s
Rearranging: B - B = M - M
As the interest rate increases:
d
If the market for money is in equilibrium (M s = M d ), s
d
then the bond market is also in equilibrium (B = B ).
The opportunity cost of holding money increases… The relative expected return of money decreases… the quantity demanded of money decreases.
Money supply is set by the Fed.
Shifts in the Demand and Supply of Money
Example: Response to a Change in Income or the Price Level
Demand for money shifts when
Income Effect: Higher income, higher demand for money.
Price-Level Effect: Higher price level, higher demand for money.
Supply for money shifts when the Federal Reserve increases money supply.
Example: Response to a Change in the Money Supply
Table 4 Factors That Shift the Demand for and Supply of Money
Application: Change in Money Supply and Interest Rate
Application: Change in Money Supply and Interest Rate
The liquidity effect: immediate
Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates.
Income effect: slow
Increasing the money supply is an expansionary influence on the economy (the demand curve shifts to the right), interest rates rises.
Price-Level effect: slow
An increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right).
Expected-Inflation effect: slow or quick
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), interest rate rises.
Expected-inflation effect persists only as long as the price level continues to rise.
Liquidity vs. Other Effects
FIGURE 11 Response over Time to an Increase in Money Supply Growth
In Friedman’s view, whether interest rate increases or decreases when money supply increases depends on:
The level of liquidity and other effects.
How fast people’s expectations for inflation adjusts.
FIGURE 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2008
Exercises
No strong support for any of the three scenarios. Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
6, 8, 11, 13, 15.
