Chapter 5

Question 1

Determinants of Asset Demand (4)

Answer 1

1. Wealth: the total resources owned by the individual, including all assets
2. Expected Return: the return expected over the next period on one asset relative to alternative assets
3. Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets
4. Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets

Question 2

What are the five things that shift the demand curve for bonds and what does an increase in each do to the demand curve?

Answer 2

Wealth: growing wealth shifts the demand curve for bonds to the right

Expected returns: higher expected future interest rates shifts the demand curve to the left

Expected inflation: an increase in the expected rate of inflations shifts the demand curve to shift to the left

Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left

Liquidity: increased liquidity of bonds shifts the demand curve to the right

Question 2

What are the three things that shift the supply curve for bonds and what does an increase in each do to the demand curve?

Answer 2

Investment opportunities: Higher expected profitability of investment opportunities shifts the supply curve to the right

Expected inflation: an increase in expected inflation shifts the supply curve to the right

Government budget: increased budget deficit shifts the supply curve to the right

Question 3

How do the determinants of asset demand affect the quantity demanded of an asset

Answer 3

• positively related to wealth
• positively related to its expected return relative to alternative assets
• negatively related to the risk of its returns relative to alternative assets
• positively related to its liquidity relative to alternative assets

Question 4

What are the five things that shift the demand curve for bonds and what does an increase in each do to the demand curve?

Answer 4

Wealth: growing wealth shifts the demand curve for bonds to the right

Expected returns: higher expected future interest rates shifts the demand curve to the left

Expected inflation: an increase in the expected rate of inflations shifts the demand curve to shift to the left

Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left

Liquidity: increased liquidity of bonds shifts the demand curve to the right

Question 5

What are the three things that shift the supply curve for bonds and what does an increase in each do to the supply curve?

Answer 5

Investment opportunities: Higher expected profitability of investment opportunities shifts the supply curve to the right

Expected inflation: an increase in expected inflation shifts the supply curve to the right

Government budget: increased budget deficit shifts the supply curve to the right

Question 6

Slides 18 and 20

Question 7

What is the relationship between the quantity of money demanded and bond market interest rate?

Answer 7

Quantity of money demanded and bond market interest rate have negative relationship, because interest rate on bonds = opportunity cost of holding money

Question 8

Explain the two most important facts about the Supply for Money in the Liquidity Preference Framework

Answer 8

Supply for money:

Assumed to be fully controlled by the central bank

This means supply curve is vertical in bond interest rate (supply is perfectly inelastic)

Question 9

What creates a shift is the demand for money.

Answer 9

Income Effect
a higher level of income causes the demand for money to increase at each given interest rate, hence demand curve shifts to the right

Price-Level Effect
a rise in the price level causes the demand for money to increase at each given interest rate, hence demand curve shifts to the right

Question 10

What conclusion does the liquidity preference framework bring us to and what is it called?

Answer 10

The liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates: the liquidity effect

Question 11

Milton Friedman felt that the liquidity effect didn’t tell the whole story, what other effects did he believe kicked in when the money supply increased?

Answer 11

Income effect describes that increasing the money supply has an expansionary influence on the economy
- the demand curve shifts to the right

Price-level effect describes that an increase in the money supply leads to a rise in the price level
- the demand curve shifts to the right

Expected-inflation effect describes that an increase in the money supply may lead people to expect a higher price level in the future
- the demand curve shifts to the right

Question 12

**Slide 33