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Transcript
Demand for an Asset • Wealth • Expected return…relative to alternative assets • Risk—uncertainty of return—relative to alternative assets • Liquidity—ease and speed an asset can be turned into cash—relative to alternative assets Interest Rate Determination: Supply and Demand for Bonds • At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship • At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship • Market equilibrium— the price where the quantity people are willing to buy equals the quantity people are willing to sell Interest Rate Determination: Supply and Demand for Money : : Liquidity Preference Framework Keynesian model that determines the equilibrium interest rate in terms of the supply of and demand for money. There are two main categories of assets that people use to store their wealth: money and bonds. Total wealth in the economy = Bs M s = Bd + M d Rearranging: Bs - Bd = M s - M d If the market for money is in equilibrium (M s = M d ), then the bond market is also in equilibrium (Bs = Bd ). Shifts in the Demand for Money • Income Effect: • Higher income more stuff bought demand for money at each interest rate increases • Price-Level Effect: • Rise in the price level need more money to buy the same amount of stuff the demand for money at each interest rate increases Shifts in the Supply of Money • Monetary Base: Controlled by Fed • Money Multiplier: (1 + c)/(c + r + e) • We’ll assume Ms controlled by Fed Interest Rate and the Money Supply • Liquidity effect: Ms up lowers interest rates But Ms up also increases output and prices • Income effect: Ms up increased output increased demand for money interest rate up • Price-Level effect: Ms up increased price level increased demand for money interest rate up • Expected-Inflation effect: Ms up expectation of ongoing inflation (maybe) interest rate up Price-Level Effect and Expected-Inflation Effect • 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 interest rate will rise via the increased prices. • Price-level effect remains even after prices have stopped rising. • A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero. • Expected-inflation effect persists only as long as the price level continues to rise.