Ch.5: The Behavior of Interest Rates

Portfolio Theory

an economic theory that outlines criteria that are important when deciding how much of an asset to buy

Market equilibrium

the point at which the quantity supplied equals the quantity demanded

Interest rates on different securities tend to move ___

together

Wealth

All resources owned by an individual, including all assets.

Expected return

The return on an asset expected over the next period

Risk

The degree of uncertainty associated with the return on an asset.

Liquidity

The relative ease and speed with which an asset can be converted into cash.

An increase in wealth ___ the quantity demanded of an asset

raises

Return on asset

how much we gain from holding that asset

An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, ___ the quantity demanded of the asset.

raises

Risk preferrer

a person who prefers risk

Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will ___.

fall

Liquidity

how quickly an asset can be converted into cash at low costs

An asset is liquid if the market in which it is trades has

many buyers and sellers

The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is and the ___ the quantity demanded will be.

greater

Theory of portfolio choice

A theory that outlines how much of an asset people will want to hold in their portfolios, as determined by wealth, expected returns, risk, and liquidity.

The quantity demanded of an asset is ___ related to wealth

positively

The quantity demanded of an asset is ___ related to its expected return relative to alternative assets.

positively

The quantity demanded of an asset is ___ related to the risk of its returns relative to alternative assets.

negatively

The quantity demanded of an asset is ___ related to its liquidity relative to alternative assets.

positively

Demand curve

The curve depicting the relationship between quantity demanded and price when all other economic variables are held constant.

Supply curve

A curve depicting the relationship between quantity supplied and price when all other economic variables are held constant.

Market equilibrium

Occurs in an economy when the quantity that people are willing to buy (demand) is equal to the quantity that people are willing to sell (supply).

The market tends to head toward

market equilibrium and price

Excess supply

A situation in which the quantity supplied is greater than the quantity demanded.

Excess demand

A situation in which the quantity demanded is greater than the quantity supplied.

Asset market approach

An approach to determining asset prices that makes use of stocks of assets rather than flows.

Movement along the demand curve

when quantity demanded changes as a result of a change in the price of the bond

Movement along the supply curve

when quantity supplied changes as a result of a change in the price of the bond

A shift in the demand curve

the quantity demanded changes at each given price (or interest rate) of the bond in response to a change in some other factors besides the bond’s price or interest rate.

A shift in the supply curve

the quantity supplied changes at each given price (or interest rate) of the bond in response to a change in some other factors besides the bond’s price or interest rate.

Increase in wealth

1. increase in quantity demanded at each bond price

2. demand curve shifts right

Increase expected interest rate

1. Decrease in quantity demanded at each bond price

2. Demand curve shifts left

Increase expected inflation

1. Decrease in quantity demanded at each bond price

2. Demand curve shifts left

Increase riskiness of bonds relative to other assets

1. Decrease in quantity demanded at each bond price

2. Demand curve shifts left

Increase liquidity of bonds relative to other assets

1. increase in quantity demanded at each bond price

2. demand curve shifts right

The supply curve for bonds to shift

1. Expected profitability of investment opportunities

2. Expected inflation

3. Government budget deficit

Increase profitability of investments

1. Increase in quantity supplied at each bond price

2. Supply curve shifts right

Increase expected inflation

1. Increase in quantity supplied at each bond price

2. Supply curve shifts right

Increase government deficit

1. Increase in quantity supplied at each bond price

2. Supply curve shifts right

Liquidity preference framework

A model developed by John Maynard Keynes that predicts the equilibrium interest rate on the basis of the supply of and demand for money.

Opportunity Cost

The amount of interest (expected return) sacrificed by not holding an alternative asset.

When income is rising during a business cycle expansion, interest rates will ___

rise

When the price level increases, with the supply of money and other economic variables help constant, interest rates will ___

rise

When the money supply increases, interest rates will ___

decline

Milton Friedman’s Liquidity Effect

An increase in the money supply lowers interest rates

Income effect

the income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income.

Price-level effect

the price-level effect from an increase in the money supply is a rise in interest rates in response to the rise in price level.

Expected-inflation effect

the expected-inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate.