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Chapter 3 behavior of interest rate

Chapter 3 behavior of interest rate. Ⅰdeterminants of asset demand. 1. determinants of asset demand (1)wealth total resources owned by individual, including all assets (2)expected return the return expected over the next period on one asset relative to alternative assets. (3)Risk

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Chapter 3 behavior of interest rate

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  1. Chapter 3 behavior of interest rate

  2. Ⅰdeterminants of asset demand • 1. determinants of asset demand • (1)wealth • total resources owned by individual, including all assets • (2)expected return • the return expected over the next period on one asset relative to alternative assets

  3. (3)Risk • the degree of uncertainty associated with which an asset relative to alternative assets. • (4)Liquidity • the ease and speed with which an asset can be turned into cash relative to alternative assets.

  4. Table 1.Determinants and asset demand

  5. 2.Theory of asset demand: (1)the quantity demanded of asset is positively related to wealth. (2)the quantity demanded of assets is positively related to its expected returns relative to alternative assets

  6. (3)the quantity demanded of assets is negatively related to the risk relative to alternative assets (4)the quantity demanded of an asset is positively related to its liquidity relative to alternative assets.

  7. ⅡLoanable funds framework: supply and demand in bond market • 1.framework of loanable funds • 2.shift of demand for bonds: (1)wealth (2)expected returns on bonds relative to alternative asset (3) risk of bonds relative to alternative assets (4)liquidity of bonds relative to alternative assets

  8. 3.shift in the supply of bonds • (1)expected profitability of investment opportunity • (2)expected inflation • (3)government activity • government deficit increase (finance deficit by issue bonds)

  9. 4.the fisher effect • When expected inflation rises , interest rate will rise.

  10. 5.business cycle expansion and interest rate • When Business cycle is in expansion, both supply and demand of bond will increase, the new equilibrium interest rate can either rise or fall.

  11. Ⅲ liquidity preference framework: supply and demand in the market for money 1.assumption • (1)There are two main categories of assets: money (includes currency and checking account which has a zero rate of return) and bonds. • (2)Assumed the bonds have the expected return equal to the interest rate.

  12. 2.equilibrium in money market • 3.changes in equilibrium • (1)shift in money demand curve • A. changes of income • B. price level • (2)shift in money supply curve

  13. Discussion: • will The increase of money supply really lower interest rate?

  14. There are many effect when money supply increase, therefore increase of money supply will not necessarily lower interest rate.

  15. Ⅳmoney and interest rate • 1.the effect of changes in money supply • (1)income effect • (2)price level effect • (3)expected-inflation effect

  16. 2.the relationship between money supply and interest rate • the change of interest rate is determined by the function of price level effect, income effect, expected inflation effect and liquidity effect .

  17. If liquidity effect larger than other effects, then the new equilibrium interest rate will decline. • If liquidity effect smaller than other effects, then the new equilibrium interest rate will rise. • If liquidity effect smaller than expected inflation effect and fast adjustment of expected inflation, then the new equilibrium interest rate will rise

  18. Summary • 1.Theory of asset demand is (1)the quantity demanded of asset is positively related to wealth;(2)the quantity demanded of assets is positively related to its expected returns relative to alternative assets;(3)the quantity demanded of assets is negatively related to the risk relative to alternative assets;(4)the quantity demanded of an asset is positively related to its liquidity relative to alternative assets.

  19. 2.Loanable funds framework state that interest rate is determined by the demand and supply of bonds. Therefore changes in income (wealth), expected return, risk or liquidity can influence interest by its influence on the demand and supply of bonds.

  20. 3.liquidity preference framework shows that interest rate is determined by the supply and demand of money, supply of money is determined by central bank ,therefore a change in money demand which lead by changes of income or price level and change of money supply will influence interest rate.

  21. 4.liquidity effect indicates that when money supply growth interest rate will decline, but income effect, expected inflation effect, and price level effect indicate that interest rate will rise when money supply increase. therefore in order to figure out the relationship between money supply and interest consider liquidity effect, income effect, expected inflation effect, and price level effect together

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