Lecture 6 - The behaviour of interest rates

Question 1

Why are assets useful?

Answer 1

They can be a store of value and may generate a stream of future services or payments.

Question 2

What is wealth?

Answer 2

The total resources owned by the individual, including all assets.

Question 3

What is expected return?

Answer 3

The return expected over the next period on one asset relative to alternative assets.

Question 4

What is risk?

Answer 4

The degree of uncertainty associated with the return on one asset relative to alternative assets.

Question 5

What is liquidity?

Answer 5

The ease and speed with which an asset can be turned into cash relative to alternative assets.

Question 6

Holding everything constant, an increase in wealth…

Answer 6

Raises the quantity demanded of an asset.

Question 7

An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged…

Answer 7

Raises the quantity demanded of the asset.

Question 8

Holding everything else constant, if an asset’s risk rises relative to that of an alternative assets…

Answer 8

Its quantity demanded will fall.

Question 9

The more liquid an asset relative to alternative assets, holding everything else unchanged, the more desirable it is, and…

Answer 9

The greater will be quantity demanded.

Question 10

The quantity demanded of an asset is negatively related to…

Answer 10

The risk of the expected returns relative to alternative assets.

Question 11

The quantity demanded of an asset is positively related to…

Answer 11

Wealth, its expected returns relative to alternative assets and its liquidity relative to alternative assets.

Question 12

When does market equilibrium occur?

Answer 12

When the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. Bd = Bs. Once the market equilibrium is reached, agents do not have any incentive to change their behaviour.

Question 13

What is one thing that affects wealth?

Answer 13

The public’s propensity to save. If households save more, wealth increases and the demand for bonds rises and the demand curve for bonds shifts right. Conversely, if people save less, wealth and the demand for bonds will fall and the demand curve for bonds shifts left.

Question 14

Higher expected interest rates in the future lower the expected return for long term bonds…

Answer 14

Decrease the demand for bonds and shifts the demand curve left.

Question 15

Lower expected interest rates in the future…

Answer 15

Increase the demand for long term bonds and shift the demand curve for bonds to the left.

Question 16

An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to…

Answer 16

Decline and the demand curve to shift to the left.

Question 17

If prices in the bond market become more volatile, the risk associated with bonds increase and bonds become a less attractive asset. An increase in the riskiness of bonds causes the demand for bonds to…

Answer 17

Fall and the demand curve to shift to the left.

Question 18

An increase in the volatility of prices in another asset market, such as the stock market, would make bonds more attractive. An increase in the riskiness of alternative assets causes the demand for bonds to…

Answer 18

Rise and the demand curve to shift right.

Question 19

If more people started trading in the bond market, and as a result it became easier to sell bonds quickly, the increase in their liquidity would cause the quantity of bonds demanded at each interest rate to…

Answer 19

Rise and the demand curve would shift right..

Question 20

The increased liquidity of alternative assets…

Answer 20

Lowers the demand for bonds and shifts the demand curve to the left.

Question 21

In a business cycle expansion, the supply of bonds…

Answer 21

Increases and the supply curve shifts to the right.

Question 22

In a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds…

Answer 22

Falls and the supply curve shifts to the left.

Question 23

When expected inflation rate increases, the real cost of borrowing falls; hence the quantity of bonds supplied…

Answer 23

Increases at any given bond price and the supply curve shifts to the right.

Question 24

Higher government deficits…

Answer 24

Increase the supply of bonds and shifts the supply curve to the right.

Question 25

Government surpluses…

Answer 25

Decrease the supply of bonds and shift the supply curve to the left.

Question 26

What impact does negative inflation have?

Answer 26

The demand for bonds rises because the expected return on real assets falls and hence the demand curve shifts right. It also raises the real interest rate and hence the cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift left.