Stocks:
(0.2x0.15)+(0.3x0.083)+(0.2x0.1)+(0.3x0.05) = 0.0899 expected return
Bonds:
(0.4x0.15)+(0.6x0.05) = 0.09 expected return
Commodities
(0.2x0.2)+(0.25x0.12)+(0.25x0.06)+(0.2x0.05)+(0.1x0.001) = 0.0951 expected return
You should invest in Commodities, to maximise potential returns.
The supply and demand of the bond market illustrates that issuing more bonds will raise the
interest rates, as the price of the bonds will fall, and thus the interest rates will rise. This is
inline with what the liquidity preference will say, as a decrease in the money supply,
indicates a rise in the interest rates.
When the economy is expanding, interest rates are rising. This can be illustrated in the rises
from r1 to r2 in the analysis of the liquidity framework. When the economy is contracting,
the interest rate falls, as shown by the fall from r2 to r1 in the analysis of the liquidity
framework. This is caused by an outward shift in the demand for money.
This can also be illustrated in the supply and demand model for bonds, this shows that when
the economy is expanding, the supply and demand for bonds increase such that the prices of
bonds rise, meaning the interest rates fall (p1-p2). And when the economy is shrinking, the
supply and demand of bonds shifts inwards, and the price rises, making the interest rates fall
(p2-p1)
In the liquidity preference.
If the economy is growing, incomes are rising, as to is wealth. People will demand more
money, one to use as a store of wealth, as the framework only takes money and bonds as
stores of wealth, and two to consume more. This is because consumers need money to
consume. The demand for money increases, which means money has a higher interest rate.
The opposite applies in a recession, people’s wealth declines, they make less transactions,
and thus they demand less money, and the interest rate goes down.
In the supply and demand for bonds:
When the economy is in an expansion, people have more wealth as described above.
Assuming not all of that wealth is spent, an attempt to save some of that wealth will
increase the demand for a financial asset, in this case bonds. This will drive up the price of
bonds. However, investment opportunities will be created in the economy, as is common in
an expanding economy. This means the supply of bonds will increase as firms look to finance
more expenditure, and thus the supply of bonds will increase. The supply usually increases
more than the demand, as not all of the increased in households goes into bonds, some goes
into consumption. This means the price falls, and hence interest rise. The opposite can be
concluded during a recession.
This shoes that interest rates are pro-cyclical.
Bond, supply and demand
If a bond becomes more risky, it will decrease the demand for the bond, as cetris paribus,
other assets are relatively less risky. This means demand for the bond will fall, and hence
the price of the bond will fall. This means that the interest rate of the bond will rise, as a
higher interest rate is required to compensate for a riskier asset. If a bond becomes less
risky, then opposite applies, and demand for the bond increases, and the interest rates fall
as the price rises. This is because investors are risk averse.
Liquidity preference framework
If bonds become riskier, then in the liquidity framework, the only other asset available is
money. As money has become less risky, cetris paribus, the demand for money has
increased. Increasing the demand for money, means the interest rates rise. The opposite
applies if we make the investment of a bond less risky, this means money is comparatively
riskier, cetris paribus, and thus the demand for money falls, and interest rates fall.
If the federal reserve sells 90 new bonds, this means the quantity supplied of bonds
becomes BS = -720+P +90 = -630+P
Before the increase in bond supply, equilibrium price was 964.44 and quantity was 244.44
After the increase in bond supply, equilibrium price was 924.22 and quantity was 294.44
The equilibrium price has decreased by 40, and the equilibrium quantity increased by 50.
The bank of England
increased the markets
interest rates by 3.26%