C5: The Beahviour of Interest Rates

What is an asset in economic terms?

A piece of property that serves as a store of value.

What are the four key determinants of the quantity demanded of an asset?

Wealth, expected return, risk, and liquidity.

How does an increase in wealth typically affect asset demand?

It increases the quantity demanded of assets overall.

Why is expected return considered relative rather than absolute?

Because investors choose between assets, not assets in isolation.

What is risk in the context of asset demand?

The degree of uncertainty associated with an asset’s return.

How does higher relative risk affect asset demand for risk-averse investors?

It lowers the quantity demanded of the asset.

What is liquidity?

The ease and speed with which an asset can be converted into cash without loss.

Why does greater liquidity increase asset demand?

Because investors value flexibility and access to cash.

Why must risk, return, and liquidity always be evaluated relative to other assets?

Because asset choice is fundamentally a comparison among alternatives.

How does an increase in wealth affect the quantity demanded of assets?

It increases the quantity demanded.

Why does higher wealth increase asset demand?

Because individuals have more resources available to purchase and hold assets.

In a demand-curve diagram, how is an increase in wealth shown?

As a rightward shift of the demand curve.

Is an increase in wealth a movement along the demand curve or a shift of the curve

A shift of the demand curve.

Why is wealth considered a constraint rather than a preference?

Because it limits how many assets an individual can afford to hold.

What happens to asset demand if wealth falls, holding everything else constant?

The quantity demanded of assets falls.

What is expected return?

The probability-weighted average of possible returns on an asset.

Why does expected return influence asset demand?

Investors prefer assets with higher expected returns, holding other factors constant.

Why must expected return be evaluated relative to alternative assets?

Because investors choose between assets, not assets in isolation.

What happens to asset demand if its expected return rises relative to alternatives?

The quantity demanded increases.

Can relative expected return increase even if an asset’s own return is unchanged?

Yes, if the expected return on alternative assets falls.

What is risk in asset-demand theory?

The degree of uncertainty associated with an asset’s return.

What does it mean for two assets to have the same expected return but different risk?

One asset has more variability in outcomes than the other.

What is a risk-averse investor?

An investor who prefers lower risk to higher risk for a given expected return.

How does higher relative risk affect asset demand for most people?

It lowers the quantity demanded.

What is liquidity?

The ease and speed with which an asset can be converted into cash at low cost.

Why are houses considered illiquid assets?

They take time to sell and involve high transaction costs.

Why are Treasury bills considered highly liquid?

They trade in deep, well-organized markets and can be sold quickly at low cost.

How does higher relative liquidity affect asset demand?

It increases the quantity demanded.

What is the theory of portfolio choice?

A framework explaining how much of each asset people hold based on wealth, expected return, risk, and liquidity.

According to portfolio choice theory, how is asset demand related to wealth?

Positively.

According to portfolio choice theory, how is asset demand related to expected return and liquidity?

Positively, relative to alternative assets.

According to portfolio choice theory, how is asset demand related to risk?

Negatively, relative to alternative assets.

What is the relationship between bond prices and interest rates?

They are negatively related.

Why is the bond demand curve downward-sloping?

Lower bond prices imply higher interest rates and higher expected returns, increasing quantity demanded.

Why is the bond supply curve upward-sloping?

Higher bond prices imply lower interest rates, making borrowing cheaper and increasing quantity supplied.

What does bond supply represent economically?

The amount of borrowing through bond issuance.

What is market equilibrium in the bond market?

The point where quantity demanded equals quantity supplied.

What is excess supply in the bond market?

A situation where quantity supplied exceeds quantity demanded.

What happens to bond prices when there is excess supply?

Bond prices fall and interest rates rise.

What is excess demand in the bond market?

A situation where quantity demanded exceeds quantity supplied.

What happens to bond prices when there is excess demand?

Bond prices rise and interest rates fall.

Why does the market tend to move toward equilibrium?

Excess supply and excess demand create price pressures that eliminate imbalances.

What is the difference between a movement along a bond demand curve and a shift of the curve?

A movement is caused by a change in bond price; a shift is caused by changes in other variables.

What happens to equilibrium interest rates when bond demand or supply curves shift?

A new equilibrium bond price and interest rate are established.

How does an increase in wealth affect bond demand?

It increases bond demand and shifts the demand curve to the right.

How do expectations of higher future interest rates affect long-term bond demand?

They lower expected returns and shift bond demand to the left.

How do expectations of lower future interest rates affect long-term bond demand?

They raise expected returns and shift bond demand to the right.

How does an increase in expected returns on alternative assets affect bond demand?

It lowers bond demand and shifts the demand curve left.

How does higher expected inflation affect bond demand?

It lowers the expected real return on bonds and shifts demand left.

How does increased riskiness of bonds affect bond demand?

It reduces bond demand and shifts the demand curve left.

How does increased riskiness of alternative assets affect bond demand?

It increases bond demand and shifts the demand curve right.

How does increased liquidity of bonds affect bond demand?

It increases bond demand and shifts the demand curve right.

Which three factors shift the supply curve for bonds?

Expected profitability of investment opportunities, expected inflation, and government budget deficits.

How does higher expected profitability of investment affect bond supply?

It increases bond supply and shifts the supply curve right.

How does higher expected inflation affect bond supply?

It lowers real borrowing costs and increases bond supply, shifting the curve right.

How do larger government budget deficits affect bond supply?

They increase bond supply and shift the supply curve right.

What happens to equilibrium interest rates when bond demand shifts right?

Bond prices rise and interest rates fall.

What happens to equilibrium interest rates when bond supply shifts right?

Bond prices fall and interest rates rise.

What is the liquidity preference framework?

A model that determines the equilibrium interest rate using the supply of and demand for money.

What two assets do people hold in the liquidity preference framework?

Money and bonds.

Why are the bond-market and money-market frameworks equivalent?

Because equilibrium in one market implies equilibrium in the other.

Why does the liquidity preference framework ignore real assets?

Because it assumes only money and bonds exist.

Why is money assumed to have a zero rate of return in Keynes’s framework?

Because currency and chequing deposits earned little or no interest.

What is the opportunity cost of holding money?

The interest income forgone by not holding bonds.

How does an increase in the interest rate affect the quantity of money demanded?

It decreases the quantity of money demanded.

Why is the money demand curve downward-sloping?

Because higher interest rates raise the opportunity cost of holding money.

How is the supply of money represented in the diagram?

As a vertical line fixed by the central bank.

What determines the equilibrium interest rate in the liquidity preference framework?

The intersection of money demand and money supply.

What happens when the interest rate is above its equilibrium level?

There is excess supply of money and the interest rate falls.

What happens when the interest rate is below its equilibrium level?

There is excess demand for money and the interest rate rises.

How does excess supply of money affect bond prices?

It raises bond prices and lowers interest rates.

How does excess demand for money affect bond prices?

It lowers bond prices and raises interest rates.

What is the key intuition behind liquidity preference?

Interest rates adjust so that people are willing to hold the available quantity of money.

Why does higher income increase the demand for money?

Because wealth rises and transaction needs increase.

How does a rise in income affect the money demand curve?

It shifts the curve to the right.

Why does the price level affect money demand?

Because people care about real money balances (purchasing power).

How does a rise in the price level affect money demand?

It increases money demand and shifts the curve to the right.

What happens when there is excess demand for money?

People sell bonds, bond prices fall, and interest rates rise.

What happens when there is excess supply of money?

People buy bonds, bond prices rise, and interest rates fall.

Why is the effect of income on interest rates unambiguous in the liquidity preference framework?

Because higher income always increases money demand when money supply is fixed.

What does the liquidity preference framework initially predict about money supply and interest rates?

An increase in the money supply lowers interest rates (the liquidity effect).

What is the liquidity effect?

The immediate decline in interest rates caused by an increase in the money supply, holding other factors constant.

Why did Friedman argue the liquidity effect is incomplete?

Because money growth affects income, prices, and inflation expectations.

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

Rising income increases money demand and raises interest rates.

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

Higher prices increase money demand and raise interest rates.

What is the expected-inflation effect?

Higher expected inflation raises nominal interest rates.

Why are the price-level effect and expected-inflation effect different?

One depends on the level of prices; the other depends on expected inflation.

Which effect persists after prices stop rising?

The price-level effect.

Which effect disappears once inflation expectations return to normal?

The expected-inflation effect.

What is required for the expected-inflation effect to persist?

A sustained increase in the growth rate of the money supply.

Which effect operates most quickly after money growth increases?

The liquidity effect.

Why do the income and price-level effects take longer to operate?

Because income and prices adjust gradually.

What determines how fast the expected-inflation effect operates?

How quickly people adjust their inflation expectations.

In which scenario do interest rates fall permanently after money growth increases?

When the liquidity effect dominates all other effects.

In which scenario do interest rates fall temporarily and then rise above their original level?

When other effects dominate but inflation expectations adjust slowly.

In which scenario do interest rates rise immediately after money growth increases?

When the expected-inflation effect dominates and expectations adjust rapidly.

What does historical evidence suggest about money growth and interest rates?

Higher money growth has often been associated with higher interest rates.

Which effect appears to dominate in the long run?

The expected-inflation effect.

Is increasing money supply growth a reliable way to lower interest rates?

No, because non-liquidity effects often dominate.