CFS Chapter 5: The Behaviour of Interest Rates

What are the four factors that determine asset demand?

1. Wealth

2. expected return

3. risk

4. liquidity

How does wealth affect the quantity demanded of an asset?

An increase in wealth increases the quantity demanded of an asset.

What is expected return?

The probability-weighted average of an asset's possible returns.

How does an increase in expected return affect asset demand?

It increases demand when the return rises relative to alternative assets.

What happens to asset demand when the risk of an asset increases?

Demand for the asset decreases relative to alternatives.

What does risk-averse mean?

Prefer less risky assets when expected returns are equal.

What does risk-loving mean?

Prefer riskier assets when expected returns are equal.

What is liquidity?

The ease and speed of converting an asset into cash at low cost.

How does greater liquidity affect asset demand?

Greater liquidity increases demand for the asset.

Why are houses relatively illiquid?

• They can take time to sell

• and have significant transaction costs

Why are Canadian government Treasury bills highly liquid?

They can be sold quickly in an organized market with many buyers.

What does portfolio choice theory state about wealth and asset demand?

Asset demand is positively related to wealth.

What does portfolio choice theory state about expected returns?

Asset demand rises when expected return increases relative to alternatives.

What does portfolio choice theory state about risk?

Asset demand falls when risk increases relative to alternatives.

What does portfolio choice theory state about liquidity?

Asset demand rises when liquidity increases relative to alternatives.

What is the relationship between bond prices and interest rates?

Bond prices and interest rates are negatively related.

• inverse relationship

What happens to the interest rate when a bond price rises?

The interest rate falls.

What happens to the interest rate when a bond price falls?

The interest rate rises.

What is the formula for the interest rate on a one-year discount bond?

i = (F − P) / P

What does F represent in the discount bond interest-rate formula?

The bond's face value.

What does P represent in the discount bond interest-rate formula?

The bond's purchase price.

What happens to bond demand when the bond price falls?

The quantity of bonds demanded increases.

Why does the bond demand curve slope downward?

A lower bond price produces a higher expected return.

What is the slope of the bond supply curve?

The bond supply curve slopes upward.

What happens to bond supply when the bond price rises?

The quantity of bonds supplied increases.

Why does a higher bond price increase bond supply?

A higher price means a lower interest rate and cheaper borrowing.

What is bond market equilibrium?

The point where the quantity of bonds demanded equals the quantity supplied.

What is the equilibrium bond price?

The bond price at which the bond market clears.

What is the equilibrium interest rate?

The interest rate corresponding to the equilibrium bond price.

What happens when there is excess supply of bonds?

Bond prices fall until the market returns to equilibrium.

What happens when there is excess demand for bonds?

Bond prices rise until the market returns to equilibrium.

What causes a movement along a bond demand or supply curve?

A change in the bond's price or interest rate.

What causes a shift in a bond demand or supply curve?

A factor other than the bond's own price or interest rate.

What happens to bond demand when wealth increases?

Bond demand increases and the demand curve shifts right.

What happens to bond demand during a recession?

Lower wealth decreases bond demand and shifts demand left.

What happens to bond demand when expected future interest rates rise?

Bond demand decreases and the demand curve shifts left.

What happens to bond demand when expected inflation rises?

Bond demand decreases and the demand curve shifts left.

What happens to bond demand when bond risk increases?

Bond demand decreases and the demand curve shifts left.

What happens to bond demand when bond liquidity increases?

Bond demand increases and the demand curve shifts right.

What happens to bond demand when alternative assets become more attractive?

Bond demand decreases.

What happens to bond demand when alternative assets become riskier?

Bond demand increases.

What happens to bond demand when alternative assets become less liquid?

Bond demand increases.

What happens to bond supply when investment opportunities become more profitable?

Bond supply increases and the supply curve shifts right.

What happens to bond supply during an economic expansion?

• Investment opportunities increase

• causing bond supply to increase

What happens to bond supply during a recession?

• Fewer profitable investment opportunities

• decrease bond supply

What happens to bond supply when expected inflation rises?

Bond supply increases because the real cost of borrowing falls.

What happens to bond supply when the government budget deficit increases?

Bond supply increases because the government issues more bonds.

What happens to bond supply when the government has a surplus?

Bond supply decreases.

What is the Fisher effect?

• An increase in expected inflation

• causes nominal interest rates to rise

What happens to bond demand when expected inflation rises?

Bond demand shifts left.

What happens to bond supply when expected inflation rises?

Bond supply shifts right.

What happens to the equilibrium bond price when expected inflation rises?

The equilibrium bond price falls.

What happens to the equilibrium interest rate when expected inflation rises?

The equilibrium interest rate rises.

What happens to interest rates during a typical business expansion?

Interest rates tend to rise during expansions.

What happens to interest rates during a recession?

Interest rates tend to fall during recessions.

What is the liquidity preference framework?

• A Keynesian framework

• that determines interest rates

• using money supply and demand

What two assets does Keynes assume people hold?

Money and bonds.

What is the equilibrium condition in the money market?

Money demanded equals money supplied.

What happens to money demand when the interest rate rises?

The quantity of money demanded decreases.

Why does higher interest reduce the quantity of money demanded?

It increases the opportunity cost of holding money.

What is the slope of the money demand curve?

The money demand curve slopes downward.

What happens when the interest rate is above equilibrium?

• There is excess money supply

• causing people to buy bonds

• and interest rates to fall

What happens when the interest rate is below equilibrium?

• There is excess money demand

• causing people to sell bonds

• and interest rates to rise

What happens to money demand when income rises?

Money demand increases and shifts right.

Why does higher income increase money demand?

Higher income increases transactions and wealth, increasing desired money holdings.

What happens to money demand when the price level rises?

Money demand increases and shifts right.

Why does a higher price level increase money demand?

People need more nominal money to maintain their purchasing power.

Who controls the money supply according to the chapter?

The central bank, specifically the Bank of Canada.

What happens when the Bank of Canada increases the money supply?

The money supply curve shifts right.

What happens to the equilibrium interest rate when money supply increases?

The equilibrium interest rate initially falls.

What is the liquidity effect?

• The immediate decrease in interest rates

• caused by an increase in money supply

What is the income effect of an increase in money supply?

Higher money supply raises income, increasing interest rates.

What is the price-level effect of an increase in money supply?

• Higher money supply

• raises the price level

• increasing interest rates

What is the expected-inflation effect of an increase in money supply?

• Higher money growth raises expected inflation

• increasing interest rates

What happens to interest rates through the liquidity effect?

Interest rates decrease.

What happens to interest rates through the income effect?

Interest rates increase.

What happens to interest rates through the price-level effect?

Interest rates increase.

What happens to interest rates through the expected-inflation effect?

Interest rates increase.

What is the difference between the price-level and expected-inflation effects?

• Price level concerns the level of prices

• Expected inflation concerns expected price increases

Why can an increase in money supply eventually raise interest rates?

Income, price-level, and expected-inflation effects can outweigh the liquidity effect.

What happens to interest rates immediately after an increase in money supply?

The liquidity effect tends to lower interest rates.

What can happen to interest rates over time after money supply increases?

Income, price-level, and expected-inflation effects can cause rates to rise.

What did historical evidence from 1968–2020 show about money growth and interest rates?

• Higher money growth

• was associated with higher interest rates

• especially during the 1970s

What happens when the money supply increases and the liquidity effect dominates?

Interest rates decrease overall.

What happens when the expected-inflation effect dominates?

Interest rates can rise immediately and continue rising.