3. Change in interest rates

Determinants of asset demand

1. Wealth: total resources owned by individual

2. Expected return: return expected over the next period of an asset relative to alternative assets

3. Risk: degree of uncertainty associated with the return of an asset relative to alternative assets

4. Liquidity: ease with which an asset can be turned into cash relative to alternative assets

Expected returns

Weighted average of all possible returns
R^e = p₁R₁ + … + p_nR_n

Risk

Measured with standard deviation

o = √p₁(R₁ - R^e) + p₂(R₂ - R^e) + … + p_n(R_n - R^e)

Given two assets with the same expected return, an individual is risk-averse if they prefer the one with the lower o

Theory of portfolio choice

AEE, ↑ wealth, ↑quantity demanded

AEE, ↑ expected returns, ↑quantity demanded

AEE, ↑ risk, ↓ quantity demanded

AEE, ↑ liquidity, ↑ quantity demanded

Shifts in the demand of bonds (AEE)

1. ↑ wealth, demand shifts right

2. ↑expected interest rate, ↓ expected returns, demand shifts left
   ↑expected inflation, ↓ expected returns, demand shifts left

3. ↑risk (relative to other assets), demand shifts left

4. ↑liquidity (relative to other assets), demand shifts right

Shifts in the supply of bonds (AEE)

1. ↑ expected profitability of investment opportunities, supply shifts right

2. ↑ expected inflation, supply shifts right

3. ↑ government deficit, supply shifts right

Fisher effect

If expected inflation rises, interest rates rise

↑ expected inflation: demand shifts left, supply shifts right

equilibrium price falls, interest rate rises

Changes in int. rate due to a business cycle expansion

Demand & supply shift to the right; ambiguous effect on price/intererst rates

Supply: more goods and services being produced, businesses have profitable investment opportunities; supply shifts right

Demand: wealth increases, demand shifts right