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ES10002- Introduction to Macroeconomics > Topic 5 > Flashcards

Topic 5 Flashcards

1
Q

What is an asset market?

A

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

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2
Q

What is portfolio theory?

A

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

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3
Q

What is a portfolio?

A

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

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4
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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5
Q

What are the 4 characteristics of assets that affect the portfolio allocation decision?

A

Expected return, wealth, risk, liquidity & time to maturity (for bonds)

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6
Q

What is the Fisher equation?

A

π‘…π‘’π‘Žπ‘™ π‘–π‘›π‘‘π‘’π‘Ÿπ‘’π‘ π‘‘ π‘Ÿπ‘Žπ‘‘π‘’ (π‘Ÿ) = π‘›π‘œπ‘šπ‘–π‘›π‘Žπ‘™ π‘–π‘›π‘‘π‘’π‘Ÿπ‘’π‘ π‘‘ π‘Ÿπ‘Žπ‘‘π‘’ (𝑖) βˆ’ π‘–π‘›π‘“π‘™π‘Žπ‘‘π‘–π‘œπ‘› π‘Ÿπ‘Žπ‘‘π‘’(πœ‹)

r = i - pi

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7
Q

How do you calculate expected real return?

A

𝐸π‘₯𝑝𝑒𝑐𝑑𝑒𝑑 π‘Ÿπ‘’π‘Žπ‘™ π‘Ÿπ‘’π‘‘π‘’π‘Ÿπ‘› = π‘›π‘œπ‘šπ‘–π‘›π‘Žπ‘™ π‘Ÿπ‘’π‘‘π‘’π‘Ÿπ‘› βˆ’ 𝑒π‘₯𝑝𝑒𝑐𝑑𝑒𝑑 π‘–π‘›π‘“π‘™π‘Žπ‘‘π‘–π‘œn

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8
Q

How do you calculate the relative return of asset a relative to asset b?

A

Ra / Rb

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9
Q

What does an increase in wealth do to quantity demanded of an asset?

A

All else equal, an increase in wealth raises the quantity demanded of an asset

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10
Q

What is risk?

A

Risk is the degree of uncertainty in an asset’s (nominal or expected real) return

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11
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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12
Q

What is liquidity ?

A

The ease and quickness with which an asset can be traded

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13
Q

What is the most liquid asset?

A

Money

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14
Q

Do investors prefer more liquid assets?

A

Yes

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15
Q

What is the equation for the demand function for a one-year discount bond?

A

i = R^e = F / Pb -1

R^e = expected return
F= Face value
Pb= Price of bond

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16
Q

What does a lower price of a bond imply?

A

A higher rate of return of bonds

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17
Q

What does the demand curve of bond show?

A

The relationship between the QD of bonds and the bond price

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18
Q

What are the factors that shift the demand curve for bonds?

A

Wealth
Expected return
Expected rate of inflation
Risk
Liquidity

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19
Q

How does wealth affect the demand for a bond?

A

Increase in wealth increases demand

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20
Q

How does expected return affect the demand for a bond?

A

An increase in a bond’s expected return relative to that of an alternative asset, increases the demand for a bond

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21
Q

In our unit, we only consider one-year discount bonds, what does this mean for the expected return of a bond?

A

R^e = i

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22
Q

How do you denote the expression for the relative return of a bon?

A

Look at slides

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23
Q

What does an increase in the expected rate of inflation do to the demand of bonds?

A

An increase in the expected rate of inflation lowers the demand of bonds

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24
Q

How does an increase in the expected rate of inflation cause a decrease in the demand for bonds?

A

Using the formula:
R^e = i (1 - t) - pi^e

Therefore the decrease will cause a fall in R^e

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25
Q

What is another effect of an increase in expected inflation?

A

Higher prices of real assets in the future, hence higher nominal capital gains

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26
Q

So, referring to the change in price of future real assets, how does an increase in expected inflation effect the demand for bonds?

A

Demand for bonds will fall because a rise in the expected returns on these real assets, that are expected to increase in price, will lower the expected return on bonds relative to the expected return on real assets

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27
Q

How does risk associated with the return on bonds effect the demand for bonds?

A

If this risk increases relative to that of alternative assets, the demand for bonds will decrease

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28
Q

How does liquidity effect the demand for bonds?

A

The demand for a bond rises as its liquidity increases relative to the liquidity of alternative assets

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29
Q

What does the supply curve of a bond represent?

A

Shows the relationship between the price of bonds and their quantity supplied

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30
Q

What do we assume about government bonds?

A

The government supply of bonds is independent of the bonds rate of return, and thus bond price, thus the government supply is a vertical line

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31
Q

Who issues bonds?

A

The government and private corporations

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32
Q

What does the private supply of bonds look like?

A

Upwards sloping

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33
Q

How is the aggregate supply of bonds calculated? I it upwards sloping?

A

Government supply + private supply

Yes

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34
Q

What shifts the supply curve of bonds?

A

Expected profitability of investment opportunities (business cycle expansion)
Expected inflation
Government budget deficits

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35
Q

How does the expected profitability of investment opportunities affect the private supply of bonds (related to business cycle)?

A

When opportunities for profitable investments are plentiful, firms are willing to borrow. Hence, in a business cycle expansion the supply of bonds goes up and the supply increases

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36
Q

How does expected inflation effect the supply of bonds?

A

For a given i, when expected inflation rises, the real cost of borrowing falls. QS on bonds increases.

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37
Q

How do government budget deficits effect the supply of bonds?

A

Higher government budget deficits increase the government supply of bonds

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38
Q

What is the effect called that outlines changes in the interest rate due to expected inflation?

A

The Fisher Effect

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39
Q

If you get a question on how a change in the interest rate due to expected inflation effects market equilibrium, what bullet points should you include?

A
  • Increase in pi^e lowers expected real rate of return on bonds relative to real assets. Bond demand decreases
  • Real cost of borrowing falls. Supply of bonds increases
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40
Q

What is the Fisher effect?

A

When expected inflation rises, interest rates will rise

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41
Q

What does the Fisher effect look like on a diagram?

A

Increase in supply
Decrease in the demand for bonds

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42
Q

What is the effect on bond price and bond quantity due to the Fisher effect?

A

Decreased price
Quantity change hard to determine (need to know magnitudes)

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43
Q

Outline the bullet points required when analysing equilibrium when there is a change in interest rates due to a business cycle expansion?

A
  • National income rises, businesses are more willing to borrow because likely to have more profitable investment opportunities. Supply of bonds increases
  • Wealth increases leading to an increase in bond demand
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44
Q

What happens to price and quantity when there is a business cycle expansion?

A

Price hard to determine
Quantity increases

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45
Q

Define money

A

assets that are widely used and accepted as payment

46
Q

What are the 3 functions of money?

A

Medium of exchange: a device for making transactions
Unit of account: the basic unit for measuring economic value
Store of value: money can be used to hold wealth

47
Q

What are monetary aggregates?

A

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

48
Q

What is M1 monetary aggregates?

A

βœ“Currency and traveler’s checks held by the public
βœ“Transaction accounts on which checks may be drawn

49
Q

Does M1 or M2 have larger liquid assets?

A

M1

50
Q

What are the assumptions we make about bonds compared to monetary assets?

A

Bonds are less liquid and pay interest

51
Q

What is include din M2 monetary aggregates?

A

Savings deposits, small (<$100,000) time deposits, money market mutual funds (MMMF) balances, money-market deposit accounts (MMDAs)

52
Q

What is the money supply?

A

The amount of money available in the economy

53
Q

How do you calculate M2?

A

M2 = M1 + less β€˜money like’ assets

54
Q

How does the central bank increase the money supply?

A

Using newly printed money to buy financial assets from
the public –an open market purchase

55
Q

How does the central bank reduce the economy’s money stock?

A

Sells financial assets to the public to remove money
from circulation –an open market sale

56
Q

What are open market purchases and sales called?

A

Open market operations

57
Q

How else might the central bank increase the money supply?

A

By buying newly issued government bonds
directly from the government (mostly in the past)

58
Q

What letter do we use in our analysis to denote the money supply?

A

Mbar = M^s

59
Q

What does the money supply curve look like?

A

Vertical (money supply is independent of interest rates)

60
Q

What is the demand for money?

A

The optimal quantity of monetary assets that people choose to hold in their
portfolios

61
Q

What is the benefit of holding money?

A

Money is the most liquid asset

62
Q

What is the cost of holding money?

A

Money pays a low return

63
Q

What determines people’s money holding decisions?

A

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

64
Q

What is the aggregate demand for money?

A

the sum of all individual money demands (𝑀^𝑑)

65
Q

What are the macroeconomic variables that affect the money demand?

A

Price level
Real income
Interest rates
Wealth
Risk
Liquidity of alternative assets
Payment technologies

66
Q

How does the price level effect the money demand?

A

The higher the price level, the more money you need for transactions

67
Q

What is nominal money demand proportional to?

A

the price level

68
Q

How does real income effect the money demand?

A

The more transactions individuals and businesses conduct, the greater is their demand for money

69
Q

How do interest rates effect money demand?

A

An increase in the return on bonds decreases the demand for money.

An increase in the interest rate on money (𝑖^π‘š) leads to an increase in money demand

70
Q

What is the nonmonetary assets interest rates known as?

A

the opportunity cost of holding money

71
Q

What do we assume about i^m?

A

i^m = 0

72
Q

What is the real rate of return on money?

A

rm = i^m - pi

Assuming that i^m = 0:
rm = -pi

73
Q

In periods of high and erratic inflation what do people switch to? What are these?

A

Inflation hedges: assets whose real returns are less likely to be affected by inflation. Examples include gold, consumer durable
goods and real estate. We call these real assets.

74
Q

What is the money demand fucntion?

A

𝑀^𝑑 = 𝑃 Γ— 𝐿(π‘Œ, 𝑖)

M^d = nominal aggregate money demand
P = price level
L = real money demand function
Y = income
i = nominal interest rate on bonds

75
Q

What is an alternative expression of the money demand function?

A

𝑀^𝑑 = 𝑃 Γ— 𝐿(π‘Œ, π‘Ÿ + πœ‹^𝑒)

evoking Fisher equation

76
Q

What is the equation for the real money demand?

A

M^d / P

77
Q

How does wealth effect the demand for money?

A

When wealth increases money demand may increase

78
Q

How does risk effect the demand for money?

A

βœ“If the risk of alternative assets increases, money demand may increase
βœ“Times of erratic inflation bring increased risk to money, as π‘Ÿπ‘š may become quite uncertain (givena fixed nominal return 𝑖^π‘š). Money demand in nominal & real terms declines.

79
Q

How does liquidity of alternative assets effect the demand for money?

A

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

80
Q

How does payment technologies effect the money demand?

A

Innovations in payment technologies reduce money demand

81
Q

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

A

The % change in money demand caused by a 1%
change in income (π‘Œ)

82
Q

What do statistical studies show the income elasticity of money demand to be?

A

positive and less than one

83
Q

What is the equation of 𝜼Y?

A

βˆ†π‘€π‘‘/βˆ†π‘Œ x π‘Œ/𝑀^d

84
Q

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

A

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

85
Q

What do statistical studies show about πœΌπ’Š?

A

small and negative

86
Q

What is the equation of 𝜼i?

A

βˆ†π‘€π‘‘/βˆ†π‘– x 𝑖/𝑀^d

87
Q

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

A

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

88
Q

What do statistical studies show about the price elasticity of demand?

A

it is close to 1, so money demand is proportional to P

89
Q

What is the equation of πœ‚p?

A

βˆ†π‘€π‘‘/βˆ†π‘ƒ x 𝑃/𝑀^𝑑 β‰… 1

90
Q

What is the liquidity preference framework?

A

A model for determining the equilibrium interest rate developed by John Maynard Keynes

91
Q

What conditions is the equilibrium in the money market described by (liquidity preference framework)?

A

𝑀^𝑠 = 𝑀^d

𝑀bar/𝑃 = 𝐿(π‘Œ, 𝑖*)

92
Q

In the liquidity preference framework, how do you calculate wealth?

A

The quantity of money demanded plus the quantity of bonds demanded

£𝑀^𝑑 + £𝐡^𝑑 = Β£W

93
Q

In the liquidity preference framework, what do we assume happens to the public at the equilibrium interest rate?

A

At the equilibrium interest rate (𝑖*) the public optimally chooses to hold the quantity of money
supplied by the Central Bank, thus 𝑀^𝑑 = 𝑀^𝑠 = Mbar

94
Q

What happens in the liquidity preference framework when 𝑖 > 𝑖*? What is the result of this?

A

There is an excess supply of money meaning that
individuals hold more money than they optimally want to.

Individuals start buying bonds and the demand for bonds rises.
The price of bonds in the bonds market rises implying that the interest rate falls.

95
Q

What happens in the liquidity preference framework when 𝑖 < 𝑖*? What is the result of this?

A

There is an excess demand for money meaning that
individuals hold less money than they optimally want to.

People start selling bonds leading to a fall in the price of bonds in the bonds market.
The interest rate rises until it reaches the level 𝑖*.

96
Q

If the economy is at full employment, all markets are at equilibrium. What is the equation of the economy’s price level and what is it determined by? What does this equation state?

A

𝑃 =𝑀bar / 𝐿(π‘Œ, π‘Ÿ+πœ‹^𝑒)

Determined by the asset market equilibrium condition

The price level is proportional to the nominal money supply

97
Q

What is the liquidity effect?

A

An increase in the money supply will lower interest rates

98
Q

What happens in the liquidity preference framework when there is an increase in money demand?

A

𝑀^𝑑 β‡’ 𝑒π‘₯𝑐𝑒𝑠𝑠 π‘‘π‘’π‘šπ‘Žπ‘›π‘‘ π‘“π‘œπ‘Ÿ 𝑀 β‡’ ↑ 𝑆𝑒𝑝𝑝𝑙𝑦 π‘œπ‘“ π‘π‘œπ‘›π‘‘π‘  β‡’ ↓ 𝑃𝐡 β‡’ ↑ i

99
Q

What happens in the liquidity preference framework when there is an increase in the supply of money?

A

𝑀^𝑠 β‡’ 𝑒π‘₯𝑐𝑒𝑠𝑠 𝑠𝑒𝑝𝑝𝑙𝑦 π‘œπ‘“ 𝑀 β‡’ ↑ π·π‘’π‘šπ‘Žπ‘›π‘‘ π‘“π‘œπ‘Ÿ π‘π‘œπ‘›π‘‘π‘  β‡’ ↑ 𝑃𝐡 β‡’ ↓ i

100
Q

Why does an increase in the money supply cause the interest rate to fall?

A

Because of the liquidity effect

101
Q

What does falling real interest rates lead to in terms of investment and aggregate demand?

A

Private investment spending (𝐼^𝑝)
and thus aggregate demand (π‘Œπ‘Žπ‘‘) rise

102
Q

What are the 3 other effects of an increase in the money supply?

A

Income effect
Price-level effect
Expected-inflation effect

103
Q

What is the income effect in terms of an increase in money supply?

A

The rise in aggregate supply and national income (π‘Œ) leads to an increase in money demand and thus an increase in the nominal interest rate (liquidity preference framework)

104
Q

What is the price-level effect in terms of an increase in the money supply?

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. Will lead to an increase in interest rates.

105
Q

What is the expected-inflation effect in terms of an increase in the money supply?

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. The bonds supply and demand framework has shown that an increase in expected inflation will lead to
a higher level of interest rates.

106
Q

How long does the expected-inflation effect persist for?

A

Only as long as the price level continues to rise

107
Q

After a change in the money supply, how long does it take each effect to come into play?

A

The liquidity effect takes effect immediately whereas the income and price-level effects take longer to
work

108
Q

How do you determine whether interest rates will rise or fall from an increase in the money supply?

A

If the income-, price-level-, and expected inflation effects are substantial, it is possible that when
money supply increases, interest rates might also increase

109
Q

What determines the speed of the expected inflation effect?

A

Can be slow or fast depending on whether people adjust their expectations of inflation slowly or quickly when the money supply increases

110
Q

Look at slide 79 to see diagrams

A
111
Q

What does research show when the money supply increases?

A

Research shows that increased money growth temporarily lowers short-term interest rates.

ES10002- Introduction to Macroeconomics (11 decks)

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