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33 Cards in this Set

  • Front
  • Back
Monetary Policy works primarily by

Interest rates are determined by
manipulating interest rates
the demand and supply for bonds
Bonds as financial assets:
Theory of asset
demand and asset allocation. S&D for Bonds.
Loanable funds:
Supply & Demand for loanable
fund. Savings and Investment. Bond demand is one component of the aggregate supply of L.F.
Liquidity Preference:
View bonds as an alternative to holding money.
Theory of Asset Demand
Holding all other factors constant:
1. The quantity demanded of an asset is positively related to wealth
2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets
3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
Supply and Demand for Bonds
• At lower prices (higher interest rates)
• At lower prices (higher interest rates)
ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship

ceteris paribus, the quantity supplied of bonds is lower—a positive relationship
demand curve
interest rate = expected return = F-P/P
downward sloping
supply curve
upward sloping; P increases, QD increased
market equilibrium
Bd = Bs
excess supply
Bs > Bd
want to sell more bonds then pple are willing to buy, so P falls and interest rates rise
excess demand
Bd > Bs
want to buy more bonds then others are willing to sell; P driven up and interest rates fall
asset market approach
emphasizes stocks of assets rather than flows in det. asset prices
shifts in demand curves
Wealth—in an expansion with growing wealth, the demand curve for bonds shifts to the right
• Expected Returns—higher expected interest rates in
the future lower the expected return for long-term bonds, shifting the demand curve to the left
• Expected Inflation—an increase in the expected rate
of inflation lowers the expected return for bonds,
causing the demand curve to shift to the left
• Risk—an increase in the riskiness of bonds causes
the demand curve to shift to the left
• Liquidity—increased iquidity of bonds, D curve shifts right
increase in wealth, D shifts
increase in expected interest rate, D shifts
Increase in expected inflation, D shifts
increase in riskiness of bonds, D shifts
Increase in liquidity of bonds, D shifts
shifts of demand curve in:
Factors that shift supply curves
expected profitability of investment opportunities
expected inflation
govt. budget
increase in expected profitability of investments, S shift
increase in expected inflation, S shift
increase in govt deficit, S shift
when expected inflation rises, interest rates will ____ according to the fisher effect
Liquidity preference framework
det. equilibrium interest rate in terms of the supply of and demand for money
Derivation of Demand Curve
1. Keynes assumed money has i = 0
2. As i ↑, relative RETe on money ↓ (equivalently, opportunity cost of money ↑) ⇒ Md ↓
3. Demand curve for money has usual downward slope
Derivation of Supply curve
1. Assume that central bank controls Ms and it is a fixed amount
2. Ms curve is vertical line
Market Equilibrium
1. Occurs when Md = Ms, at i* = 15%
2. If i = 25%, Ms > Md (excess supply): Price of bonds ↑, i ↓ to i* = 15%
3. If i =5%, Md > Ms (excess demand): Price of bonds ↓, i ↑ to i* = 15%
Md and interest rate should be ______ related
According to keynes, increase in income and price level shift Md
accord. to keynes, increase in Ms shifts Ms
sources of bond risk
default, inflation, interest rate
default risk
when issuer of bond is unable/unwilling to make interest pmts when promised/pay off FV when bond matures
risk premium
spread btwn interest rates on bonds w/default risk and default free bonds; indicates how much additional interest pple must earn to be willing to hold that risky bond