Money and Financial Markets (F0B001)
Ton Duc Thang University
Module 4
THE BEHAVIOR OF INTEREST RATES
Determinants of Asset Demand
The determinants of portfolio choice, also referred to as determinants of asset demand, are:
1. Wealth is the total resources owned by the individual, including all assets.
2. Expected return is the return expected over the next period on one asset relative to alternative
assets.
3. Risk is the degree of uncertainty associated with the return on one asset relative to alternative
assets.
4. Liquidity is the ease and speed with which an asset can be turned into cash relative to alternative
assets.
Theory of Portfolio Choice
Assuming ceteris paribus or holding all other factors constant [các yếu tố khác không thay đổi]:
1. The quantity demanded of an asset is positively related to wealth. (As wealth increases, the quantity
demanded of an asset also increases.)
2. The quantity demanded of an asset is positively related to its expected return relative to alternative
assets. (As the expected return of an asset increases, the quantity demanded of that asset also
increases.)
3. The quantity demanded of an asset is negatively related to the risk of its returns relative to
alternative assets. (As the risk of returns of an asset increases, the quantity demanded of that asset
decreases.)
4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
(The more liquid an asset, the higher the quantity demanded of that asset.)
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Money and Financial Markets (F0B001)
Ton Duc Thang University
Supply and Demand in the Bond Market
At lower prices (higher interest rates),
ceteris paribus, the quantity demanded
of bonds is higher. At lower prices
(higher interest rates), ceteris paribus,
the quantity supplied of bonds is lower.
Market Equilibrium
Market equilibrium occurs when the
amount that people are willing to buy
(demand) equals the amount that
people are willing to sell (supply) at a
given price.
The equilibrium price and interest rate is
determined
when
the
quantity
demanded of bonds Bd is equal to the
quantity supplied of bonds Bs .
When the quantity demanded of bonds
is greater than the quantity supplied of
bonds or Bd > Bs , there is excess
demand, price will rise and interest rate
will fall.
When the quantity demanded of bonds is less than the quantity supplied of bonds or Bd < Bs , there is
excess supply, price will fall and interest rate will rise.
Shift in the Demand for Bonds
Shifts in the demand for bonds can occur because of the following:
1. Wealth. In an expansion with growing
wealth, the demand curve for bonds
shifts to the right.
2. Expected returns. Higher expected
interest rates in the future lower the
expected return for long-term bonds,
shifting the demand curve to the left.
3. Expected inflation. An increase in the
expected rate of inflations lowers the
expected return for bonds, causing the
demand curve to shift to the left
4. Risk. An increase in the riskiness of
bonds causes the demand curve to shift
to the left.
5. Liquidity. Increased liquidity of bonds results in the demand curve shifting right.
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Money and Financial Markets (F0B001)
Ton Duc Thang University
Shifts in the Supply of Bonds
Shifts in the supply of bonds can
occur because of the following:
1. Expected
profitability
of
investment opportunities. In an
expansion, the supply curve shifts
to the right.
2. Expected inflation. An increase
in expected inflation shifts the
supply curve for bonds to the
right.
3. Government budget. Increased
budget deficits shift the supply
curve to the right.
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Money and Financial Markets (F0B001)
Ton Duc Thang University
Response to a Change in Expected Inflation
When expected inflation rises, the supply curve shifts from B1s to B2s , and the demand curve shifts from
B1d to B2d . The equilibrium moves from point 1 to point 2, with the result that the equilibrium bond price
falls from P1 to P2 and the equilibrium interest rate rises.
Response to a Business Cycle Expansion
In a business cycle expansion, when income and wealth are rising, the demand curve shifts rightward
from B1d to B2d , and the supply curve shifts rightward from B1s to B2s . If the supply curve shifts to the right
more than the demand curve, as in this figure, the equilibrium bond price moves down from P1 to P2 ,
and the equilibrium interest rate rises.
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Money and Financial Markets (F0B001)
Ton Duc Thang University
True or False
1. Risk is the uncertainty that an investment will earn its expected rate of return.
2. Investors make their choices of which assets to hold by comparing the expected return, liquidity,
and risk of alternative assets.
3. The higher the price of bonds, the greater the quantity of bonds demanded.
4. When interest rates decrease, the demand curve for bonds shifts to the left.
5. When income and wealth are rising, the demand for bonds rises and the demand curve shifts to
the right.
6. The lower the price of bonds, the smaller the quantity of bonds supplied.
7. An increase in the inflation rate will cause the demand curve for bonds to shift to the right.
8. When the government’s budget deficit decreases, the demand curve for bonds shifts to the right.
Guide Questions for Discussion
1. Explain why you would be more or less willing to buy a house under the following circumstances:
a. You just inherited 500,000,000₫.
b. Real estate commissions and real estate taxes fall.
c. You expect Petrolimex stock to double in value next year.
d. Prices in the stock market become more volatile.
e. You expect housing prices to fall.
2. Explain why each of the following changes might occur:
a. The demand curve for bonds shifts to the left.
b. The supply curve for bonds shifts to the right.
3. For each of the following situations, explain whether the demand curve for bonds, the supply
curve for bonds, or both would shift. Be sure to indicate whether the curve(s) would shift to the
right or to the left.
a. The State Bank of Vietnam publishes a forecast that the inflation rate will average 5% over the
next five years. Previously, the State Bank had been forecasting an inflation rate of 3%.
b. The economy experiences a period of rapid growth, with rising corporate profits.
c. The government runs a series of budget surpluses (excess).
d. Investors believe that the level of risk in the stock market has declined.
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