Demand and Supply of Bonds

Question 1

What are the determinants of asset demand?

Answer 1

1) Wealth
2) Expected returns
3) Risk
4) Liquidity

Question 2

What is the theory of portfolio choice?

Answer 2

Tells us how much of an asset people will want to hold in their portfolios:
- wealth – positive
- risk – negative
- liquidity – positive
- return – positive

Question 3

What are the determinants of asset supply?

Answer 3

1) Expected profit of opportunities
2) Expected inflation
3) Government budget

Question 4

What is the Fisher Effect?

Answer 4

When expected inflation rises, so does the interest rate.

Question 5

How are prices of assets and interest rates related?

Answer 5

They have a negative relationship: when P increases, interest rate decreases.

Question 6

How do interest rates change in the business cycle?

Answer 6

Expansion: interest rates increase.
Recession: interest rates decrease.

Question 7

What is secular stagnation?

Answer 7

When firms decrease investment spending by supplying fewer bonds + interest rates decrease but investment does not increase.

Question 8

Liquidity preference framework

Answer 8

Model that predicts the equilibrium interest rate on the basis of the supply of and demand for money.

Question 9

What are the determinants of demand for money?

Answer 9

1) Income effect
2) Price-level effect

Question 10

Income effect

Answer 10

A higher level of income causes the demand for money at each interest rate to increase.

Question 11

Price-level effect

Answer 11

A rise in price level causes the demand for money at each interest rate to increase.

Question 12

What are the determinants of supply of money?

Answer 12

Controlled by the central bank.

Question 13

Movement along a curve

Answer 13

Quantity of bonds demanded/supplied changes due to 𝑃 changes.

Question 14

Shift in a curve

Answer 14

Quantity of bonds demanded/supplied changes at every 𝑃 due to a change in
the factors affecting the demand and/or supply of bonds.

Question 15

What are the assumptions of the liquidity preference framework?

Answer 15

1) Wealth can be stored in either M or B
2) Money has R = 0
3) Bonds have R = interest rate

Question 16

What is the relationship between the money and bond market?

Answer 16

Excess supply in one market equals excess demand in the other market.

Question 16

What is the relationship between the money and bond market?

Answer 16

Excess supply in one market equals excess demand in the other market.

Question 17

What is the liquidity effect?

Answer 17

When the money supply increases, interest rates will decrease.

Question 18

What is the income effect when Ms increases?

Answer 18

If Ms increases, Y increases, this means wealth increases; an increase in GDP causes interest rates to increase (Bd and Bs increase).

Question 19

What are the effects of a rise in Ms?

Answer 19

1) Price level
2) Income
3) Expected inflation

Question 20

What is the price-level effect when Ms increases?

Answer 20

If Ms increases, PL increases, thus more money is needed and Md increases making interest rate increase.

Question 21

What is the expected-inflation effect when Ms increases?

Answer 21

If Ms increases, inflation increases, thus expected inflation increases, PL increases and interest rate increases (price-level effect).

Question 22

What happens to the interest rate when the liquidity effect is larger?

Answer 22

The interest rate will decline sharply due to the liquidity effect, the other effects will raise it but it will finally settle at a level below its original value.

Question 23

What happens to the interest rate when the liquidity effect is smaller?

Answer 23

The interest rate will decline limitedly due to the liquidity effect, the other effects will raise it to both counter the liquidity effect and surpass it. The interest rate thus finally settles at a level above its original value.

Question 24

What happens to the interest rate when the expected-inflation is larger?

Answer 24

The liquidity effect is completely blocked by the expected-inflation effect and continues to increase with the other effects. The final interest rate thus settles at a level above its original value.

Question 25

What are the time-lags of the liquidity, expected-inflation, income and price effects?

Answer 25

Liquidity is short-term. Exp-inflation and price effects are long-term.