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Chapter 5: Behavior of interest rates

A. Determinants of Asset demands


1. Wealth
a. the total resources owned by the individual, including all assets
b. If households save more, wealth increases and, as we have seen, the demand
for bonds rises and the demand curve for bonds shifts to the right
2. Expected Return
a. The return expected over the next period on one asset relative to the
expected return on alternative assets
b. Higher expected interest rates in the future lower the expected return for
long-term bonds, decrease the demand, and shift the demand curve to the
left.
c. Lower expected interest rates in the future increase the demand for long-
term bonds and shift the demand curve to the right
d. An increase in the expected rate of inflation lowers the expected return for
bonds, causing their demand to decline and the demand curve to shift to the
left.
3. Risk
a. The degree of uncertainty associated with the return on one asset relative to
the degree of uncertainty of alternative assets
b. An increase in the riskiness of alternative assets causes the demand for
bonds to rise and the demand curve to shift to the right
4. Liquidity
a. The ease and speed with which an asset can be turned into cash relative to
the liquidity of alternative assets
B. Supply and demand in bond market
Demand for bonds
At lower price (hi interest rates), ceteris paribus, the quantity demanded for bond is higher
negative relationship between price & quantity
Supply of Bonds
At lower prices (hi interest rates) , ceteris paribus, quantity supllied is low
Positive relationship with price and quantity

* Derivation of the demands for bonds

Market equilibrium
a. When =
b. When > (Excess supply) P , i
c. When < (Excess demand) P, i

Points in the Graph:


Demand for bonds
Point A : P = 950
(1000950)
i= = 0.053 = 5.3%, Bd = 100 billion
950
Point B : P = 900
(1000900)
i= = 0.111 = 11.1%, = 200
900
Point C: P = 850, i = 17.6% Bd = 300 billion
Point D: P = 800, i = 25.0% Bd = 400 billion
Point E: P = 750, i = 33.0% Bd = 500 billion
Supply for bonds
Point F: P = 750, i = 33.0%, Bs = 100 billion
Point G: P = 800, i = 25.0%, Bs = 200 billion
Point C: P = 850, i = 17.6%, Bs = 300 billion
Point H: P = 900, i = 11.1%, Bs = 400 billion
C. Change in equilibrium in the interest rates
1. Shifts in demands for bonds
2. Shifts in the supply of bonds
3. Change in the : Fisher effect

4. Business Cycle Expansion