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ES10002- Introductory Macroeconomics > Topic 4- The Asset Market, Money & Prices > Flashcards

Topic 4- The Asset Market, Money & Prices Flashcards

1
Q

What is the asset market?

A

The entire set of markets in which people buy and sell real and financial assets

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2
Q

Give 4 examples of assets traded in the asset market

A
  • Gold
  • Houses
  • Bonds
  • Stocks
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3
Q

What is portfolio theory?

A

A theory that specifies the determinant factors of the demand for assets

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4
Q

What is a portfolio?

A

The set of assets that a holder of wealth chooses to own

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5
Q

What is the portfolio allocation decision?

A

The decision about which assets and how much of each asset to hold

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6
Q

Give 5 main characteristics of assets which affect the portfolio allocation decision

A
  • Wealth
  • Expected return
  • Risk
  • Liquidity
  • Time to maturity (for bonds)
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7
Q

How does wealth affect the portfolio allocation decision?

A

Ceteris paribus, an increase in wealth raises the quantity demanded of an asset

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8
Q

How does expected return affect the portfolio allocation decision?

A

Ceteris paribus, investors want assets with the highest expected return

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9
Q

What is the rate of return to an asset?

A

The rate of increase in its value per unit of time

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10
Q

What is the expression for the relative return of an asset ‘A’?

A

R_a/R_b

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11
Q

How does risk affect the portfolio allocation decision?

A

Ceteris paribus, investors prefer assets with low risk

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12
Q

What is the risk of an asset?

A

The degree of uncertainty in an asset’s return

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13
Q

What is the expression for the relative risk of an asset ‘A’?

A

Risk_a/Risk_b

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14
Q

What is the risk premium?

A

The amount by which the expected return on a risky asset exceeds the return on an otherwise comparable safe asset

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15
Q

How does liquidity affect the portfolio allocation decision?

A

Ceteris paribus, investors prefer more liquid assets

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16
Q

What is liquidity?

A

The ease and quickness with which an asset can be traded

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17
Q

What is the formula for the relative liquidity of an asset ‘A’?

A

Liq_a/Liq_b

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18
Q

What is the time to maturity of a bond?

A

The amount of time until a financial security matures, and the investor is paid the principal

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19
Q

What is the formula for the expected return on a bond?

A

Expected return = Face value/Price of bond - 1

R^e = F/P_b - 1 = i

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20
Q

How would an increase in interest rates affect demand for bonds?

A

Higher interest rates make bond payments less attractive so it reduces demand

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21
Q

How would an increase in the expected rate of inflation affect the demand for bonds?

A

Higher expected inflation lowers the expected real interest rate on bonds causing their demand to decline

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22
Q

How is the demand for a bond related to its liquidity?

A

The demand for a bond is positively related to its liquidity relative to the liquidity of assets

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23
Q

What does the supply curve for government bonds look like?

A

It is completely vertical with a gradient of infinity

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24
Q

How does the interest rate affect the supply of private bonds?

A

When the interest rate is lower, the price of bonds is higher therefore it is less costly for firms to borrow by issuing bonds so they supply more

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25
Q

How is the aggregate supply curve of bonds derived?

A

By horizontally summing the private and government supply curves

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26
Q

What are 3 main factors that shift the supply of bonds?

A
  • Expected profitability of investment opportunities
  • Expected inflation
  • Government budget deficits
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27
Q

How does the expected profitability of investment opportunities affect the supply of bonds?

A

When opportunities for profitable investment are plentiful, firms are willing to borrow to finance these investments

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28
Q

How does expected inflation affect the supply of bonds?

A

For a given interest rate, when expected inflation rises, the real cost of borrowing falls. Thus, the quantity supplied of bonds increases.

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29
Q

How do government budget deficits affect the supply of bonds?

A

Higher government deficits increase the government supply of bonds and shift the aggregate supply curve to the right

30
Q

What is the Fisher effect?

A

When expected inflation rises, interest rates will rise

31
Q

How does a business expansion affect bond prices?

A

It’s ambiguous, the price of bonds can either rise or fall

32
Q

How can a business expansion increase bond prices?

A

As an economy expands, wealth increases leading to an increase in bond demand

33
Q

How can a business expansion decrease bond prices?

A

When national income rises, businesses are more willing to borrow because they are likely to have many profitable investment opportunities. Thus, the supply of bonds increases causing the equilibrium price of bonds to fall

34
Q

What is the economic definition of money?

A

Assets that are widely used and accepted as payment

35
Q

What are the 3 main functions of money?

A
  • Medium of exchange
  • Unit of account
  • Store of value
36
Q

What are money aggregates?

A

Official measures of the money stock that differ in their definition of the concept of money

37
Q

Describe the M1 aggregate

A

Currency & traveller’s checks held by the public, transaction accounts on which checks may be drawn

38
Q

Describe the M2 aggregate

A

The components of M1 plus savings deposits, small time deposits, MMMF balances, MMDAs

39
Q

What is an MMMF?

A

Money market mutual fund

40
Q

What is an MMDA?

A

Money market deposit account

41
Q

What is the money supply?

A

The amount of money available in an economy

42
Q

What is an open market purchase?

A

When the central bank increases money supply by using newly printed money to buy financial assets from the public

43
Q

What is an open market sale?

A

When the central bank sells financial assets to the public to remove money from circulation and reduce the money supply

44
Q

What is the benefit of holding money?

A

Money is the most liquid asset

45
Q

What is the cost of holding money?

A

Money pays a low return

46
Q

What do peoples’ money-holding decisions depend on?

A

Depends on how much they value liquidity against the low return on money

47
Q

What are the 4 macroeconomic variables that affect money demand?

A
  • Price Level
  • Real Income
  • Interest Rates
  • Rate of return on money
48
Q

How does the price level affect money demand?

A

The higher the price level, the more money you need for transactions so nominal money demand is proportional to the price level

49
Q

How does real income affect money demand?

A

The more transactions individuals and businesses conduct, the greater is the demand for money and real income is a prime determinant of the number of transactions

50
Q

How do interest rates affect money demand?

A

The interest rate on bonds is the opportunity cost of holding money so an increase in the return on bonds decreases the demand for money

51
Q

How does the rate of return on money affect money demand?

A

When the rate of return on money reduces, so does its demand

52
Q

What is the money demand function?

A

Nominal aggregate money demand = Price level x Real money demand function(real income, nominal interest rate on bonds)
M^d = P x L(Y,i)

53
Q

What is the expression for the real money demand?

A

M^d/P

54
Q

What are 4 other factors affecting money demand?

A
  • Wealth
  • Risk
  • Liquidity of alternative assets
  • Payment technologies
55
Q

How does wealth affect money demand?

A

When wealth increases, money demand may increase

56
Q

How does risk affect money demand?

A

If the risk of alternative assets increases, money demand may increase

57
Q

How does liquidity of alternative assets affect money demand?

A

As alternative assets become more liquid, the demand for money declines

58
Q

How do payment technologies affect money demand?

A

Innovations in payment technology reduce money demand

59
Q

What is the income elasticity of money demand (η_y)?

A

The % change in money demand caused by a 1% change in income (Y)

60
Q

What is the interest elasticity of money demand (η_i)?

A

The % change in money demand caused by a 1% change in the interest rate (i)

61
Q

What is the price elasticity of money demand (η_p)?

A

The % change in money demanded caused by a 1% change in the economy’s price level (P)

62
Q

What is the relationship between wealth and the demand for money & bonds?

A

The quantity of money demanded plus the quantity of bonds demanded must be equal to the total amount of wealth
£M^d + £B^d = £W

63
Q

How much money does the public optimally choose to hold at the equilibrium interest rate?

A

The quantity of money supplied by the central bank, thus M^d = M^s

64
Q

What happens when the interest rate is greater than the equilibrium interest rate on bonds (i>i*)?

A

There’s an excess supply of money which means that individuals hold more money than they optimally want to so they start buying bonds so the demand for bonds rises

65
Q

What happens when the interest rate is less than the equilibrium interest rate on bonds (i<i></i>

A

There’s an excess demand for money meaning that individuals hold less money than they optimally want to so people start selling bonds leading to a fall in the price of bonds due to the higher supply

66
Q

What is the asset market equilibrium condition?

A

P = M^s/L(Y,r+π^e)

67
Q

What is the liquidity effect?

A

An increase in the money supply will lower interest rates

68
Q

What is the income effect?

A

The rise in aggregate supply and national income (Y) leads to an increase in money demand and this an increase in the nominal interest rate

69
Q

What is the price level effect?

A

A one-time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year

70
Q

What is the expected-inflation effect?

A

An increase in the money supply may lead people to expect a higher price level in the future, and hence higher inflation

ES10002- Introductory Macroeconomics (6 decks)

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