Demand for assets
Goals:
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Understand the determinants of asset demand
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Understand how short-term interest rates relate to long-term
rates
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Know how bond and money markets are related
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Evaluate the effects on asset markets of real-world scenarios
Determinants of demand for assets
Determinants of demand for assets
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Wealth
Determinants of demand for assets
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Wealth
Expected return
Determinants of demand for assets
I
I
Wealth
Expected return
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↑Return ⇒ buy more
Determinants of demand for assets
I
I
Wealth
Expected return
I
I
↑Return ⇒ buy more
↑Return on alternative ⇒ buy less
Determinants of demand for assets
I
I
Wealth
Expected return
I
I
I
↑Return ⇒ buy more
↑Return on alternative ⇒ buy less
Return relative to alternatives is what matters
Determinants of demand for assets
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I
Wealth
Expected return
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I
I
I
Risk
↑Return ⇒ buy more
↑Return on alternative ⇒ buy less
Return relative to alternatives is what matters
Determinants of demand for assets
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I
Wealth
Expected return
I
I
I
↑Return ⇒ buy more
↑Return on alternative ⇒ buy less
Return relative to alternatives is what matters
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Risk
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Liquidity
Determinants of demand for assets
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Wealth
Expected return
I
I
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↑Return ⇒ buy more
↑Return on alternative ⇒ buy less
Return relative to alternatives is what matters
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Risk
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Liquidity
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Price
Demand =
Q(
Price,
−
Wealth,
+
Return,
+
Risk,
−
Liquidity
+
)
Demand for bonds
Demand for bonds
Example
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Discount bond
Demand for bonds
Example
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Discount bond
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1 year holding period and 1 year maturity
Demand for bonds
Example
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Discount bond
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1 year holding period and 1 year maturity
i = Re =
F −P
P
Demand for bonds
Example
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Discount bond
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1 year holding period and 1 year maturity
i = Re =
I
Demand falls as P rises
F −P
P
Demand for bonds
Example
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Discount bond
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1 year holding period and 1 year maturity
i = Re =
I
Demand falls as P rises
I
Demand rises as i = Re rises
F −P
P
Supply and Demand for Bonds
Discount bond with $1000 face value:
Supply of bonds
Why does supply slope up?
Supply of bonds
Why does supply slope up?
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↑P ⇒ get more for issuing bond
Supply of bonds
Why does supply slope up?
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↑P ⇒ get more for issuing bond
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↓i ⇒ lower cost of borrowing
Supply and Demand for Bonds
Discount bond with $1000 face value:
Supply and Demand for Bonds
Discount bond with $1000 face value:
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What is equilibrium?
Supply and Demand for Bonds
Discount bond with $1000 face value:
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What is equilibrium?
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How do we get there?
Supply and Demand for Bonds
Discount bond with $1000 face value:
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What is equilibrium?
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How do we get there?
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Why stock of bonds rather
than flow of purchases?
Supply and Demand for Bonds
Discount bond with $1000 face value:
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What is equilibrium?
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How do we get there?
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Why stock of bonds rather
than flow of purchases?
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What shifts the curves?
Demand shifts
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Wealth
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Expected return
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Risk
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Liquidity
↑Wealth
↑Wealth
↑Wealth
Same direction for
↑Wealth
Same direction for
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Liquidity
↑Wealth
Same direction for
I
Liquidity
I
Expected return
↑Wealth
Same direction for
I
Liquidity
I
Expected return
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Expected future price
↑Wealth
Same direction for
I
Liquidity
I
Expected return
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Expected future price
Opposite for
↑Wealth
Same direction for
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Liquidity
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Expected return
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Expected future price
Opposite for
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Expected i on other
assets
↑Wealth
Same direction for
I
Liquidity
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Expected return
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Expected future price
Opposite for
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Expected i on other
assets
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Expected inflation
↑Wealth
Same direction for
I
Liquidity
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Expected return
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Expected future price
Opposite for
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Expected i on other
assets
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Expected inflation
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Risk in bonds
What will shift the supply of bonds?
What will shift the supply of bonds?
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Expectations of investment profitability
What will shift the supply of bonds?
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Expectations of investment profitability
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Expected inflation
What will shift the supply of bonds?
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Expectations of investment profitability
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Expected inflation
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Government deficit
What shifts supply of bonds
Practice
In groups of 3–4: show using the demand and supply of bonds
what will happen to interest rates and the quantity of loans
(bonds) in each of these scenarios
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The Fed announces that they will increase the rate of inflation
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The US government decides to upgrade all its ships (at a cost
of $1.3 trillion) but does not raise taxes
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Technological advances generate the internet economy and
lead to a huge economic boom in the late 1990s
Increase in expected inflation
Increase in expected inflation
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Demand shifts back
Increase in expected inflation
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Demand shifts back
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Supply shifts out
Increase in expected inflation
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Demand shifts back
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Supply shifts out
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Price of bonds fall
Increase in expected inflation
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Demand shifts back
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Supply shifts out
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Price of bonds fall
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Interest rate rises
Increase in expected inflation
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Demand shifts back
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Supply shifts out
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Price of bonds fall
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Interest rate rises
Could get this by simply
thinking about the Fisher
equation:
i = r + πe
Inflation expectations and interest rates
Business cycle expansion
Business cycles and interest rates
Walras’ Law: money and bond markets
Two main ways to storing wealth:
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Bonds
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Money
Walras’ Law: money and bond markets
Two main ways to storing wealth:
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Bonds
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Money
Total wealth in the economy: B s + M s = B d + M d
Walras’ Law: money and bond markets
Two main ways to storing wealth:
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Bonds
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Money
Total wealth in the economy: B s + M s = B d + M d
If B s = B d , then M s = M d
Walras’ Law: money and bond markets
Two main ways to storing wealth:
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Bonds
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Money
Total wealth in the economy: B s + M s = B d + M d
If B s = B d , then M s = M d
Bond and money markets tell (almost) the same story
Opportunity cost of holding money
What do you give up to hold money?
Opportunity cost of holding money
What do you give up to hold money?
Expected real return on a bond = r
Opportunity cost of holding money
What do you give up to hold money?
Expected real return on a bond = r
What else do you give up if you hold money?
Opportunity cost of holding money
What do you give up to hold money?
Expected real return on a bond = r
What else do you give up if you hold money?
Opportunity cost = r + π
Theory of liquidity preference
Theory of liquidity preference
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What is equilibrium?
Theory of liquidity preference
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What is equilibrium?
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How do we get there?
Shifts in money demand and supply
Demand
Shifts in money demand and supply
Demand
I Income
Shifts in money demand and supply
Demand
I Income
I
More wealth ⇒ more demand for storage of wealth
Shifts in money demand and supply
Demand
I Income
I
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
Shifts in money demand and supply
Demand
I Income
I
I
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
Price level: people care about “real money balances”
Shifts in money demand and supply
Demand
I Income
I
I
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
Price level: people care about “real money balances”
Supply
Shifts in money demand and supply
Demand
I Income
I
I
I
Price level: people care about “real money balances”
Supply
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
CB
Shifts in money demand and supply
Demand
I Income
I
I
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
Price level: people care about “real money balances”
Supply
I
CB
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Banks
Shifts in money demand and supply
Demand
I Income
I
I
I
More wealth ⇒ more demand for storage of wealth
More income ⇒ more transactions
Price level: people care about “real money balances”
Supply
I
CB
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Banks
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Consumers
What will happen to interest rates when
What will happen to interest rates when
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...incomes go up?
What will happen to interest rates when
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...incomes go up?
Text said “unambiguous”, but this is only because it
assumed a restrictive money supply model
What will happen to interest rates when
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...incomes go up?
Text said “unambiguous”, but this is only because it
assumed a restrictive money supply model
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...the price level goes down?
What will happen to interest rates when
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...incomes go up?
Text said “unambiguous”, but this is only because it
assumed a restrictive money supply model
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...the price level goes down?
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...the ECB increase the money supply?
What will happen to interest rates when
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...incomes go up?
Text said “unambiguous”, but this is only because it
assumed a restrictive money supply model
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...the price level goes down?
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...the ECB increase the money supply?
Ceteris paribus
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
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Income effect
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
I
Income effect
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Price level effect
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
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Income effect
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Price level effect
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Expected inflation effect
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
I
Income effect
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Price level effect
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Expected inflation effect
Conclusions:
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
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Income effect
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Price level effect
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Expected inflation effect
Conclusions:
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Liquidity effect matters in short-run, depressing i
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
I
Income effect
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Price level effect
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Expected inflation effect
Conclusions:
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Liquidity effect matters in short-run, depressing i
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A one-time increase in the money supply has no long-run
impact on nominal or real interest rates
Correlation between i and money supply growth
Does increasing the growth rate of the money supply decrease
interest rates?
I
Income effect
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Price level effect
I
Expected inflation effect
Conclusions:
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Liquidity effect matters in short-run, depressing i
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A one-time increase in the money supply has no long-run
impact on nominal or real interest rates
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Continuous growth in the money supply increases i but not r
Interest rate spreads
Why do interest rates on 3 month treasury bills fall in a recession?
Why do interest rates on 3 month treasury bills fall in a recession?
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Monetary policy
Why do interest rates on 3 month treasury bills fall in a recession?
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Monetary policy
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Risk of other assets
Flight to security
3-MonthTreasuryBill:SecondaryMarketRate
Moody'sSeasonedBaaCorporateBondYield©
10
9
8
7
(Percent)
6
5
4
3
2
1
0
-1
2002
research.stlouisfed.org
2004
2006
2008
2010
2012
2014
Credit- rating agencies had 2 jobs
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Rate financial assets’ risk
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Advise firms on what kinds of financial products to create
Credit- rating agencies had 2 jobs
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Rate financial assets’ risk
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Advise firms on what kinds of financial products to create
⇒ Conflict of interest
Credit- rating agencies had 2 jobs
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Rate financial assets’ risk
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Advise firms on what kinds of financial products to create
⇒ Conflict of interest
Then why didn’t firms just find different rating agencies?
Credit- rating agencies had 2 jobs
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Rate financial assets’ risk
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Advise firms on what kinds of financial products to create
⇒ Conflict of interest
Then why didn’t firms just find different rating agencies?
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Ratings are costly
Credit- rating agencies had 2 jobs
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Rate financial assets’ risk
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Advise firms on what kinds of financial products to create
⇒ Conflict of interest
Then why didn’t firms just find different rating agencies?
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Ratings are costly
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Free rider problem
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Risk
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Risk
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Liquidity
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Risk
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Liquidity
Tax differences
I
I
Risk
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Liquidity
Tax differences
I
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Municipal bonds are federal-tax-free
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Risk
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Liquidity
Tax differences
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I
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Municipal bonds are federal-tax-free
How will increased federal income tax rates affect rate spread?
Term structure
Yield curves
Yield curves
Facts to explain:
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Rates for different maturities are positively correlated over
periods of multiple years
Yield curves
Facts to explain:
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Rates for different maturities are positively correlated over
periods of multiple years
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Yield curves usually positively sloped
Yield curves
Facts to explain:
I
Rates for different maturities are positively correlated over
periods of multiple years
I
Yield curves usually positively sloped
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Yield curves have higher slopes when short-term rates are low
Yield curves
Facts to explain:
I
Rates for different maturities are positively correlated over
periods of multiple years
I
Yield curves usually positively sloped
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Yield curves have higher slopes when short-term rates are low
Explanations
Yield curves
Facts to explain:
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Rates for different maturities are positively correlated over
periods of multiple years
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Yield curves usually positively sloped
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Yield curves have higher slopes when short-term rates are low
Explanations
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Long-term rates are averages of expected future short-term
rates
Yield curves
Facts to explain:
I
Rates for different maturities are positively correlated over
periods of multiple years
I
Yield curves usually positively sloped
I
Yield curves have higher slopes when short-term rates are low
Explanations
I
Long-term rates are averages of expected future short-term
rates
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Term risk
Yield curves
Facts to explain:
I
Rates for different maturities are positively correlated over
periods of multiple years
I
Yield curves usually positively sloped
I
Yield curves have higher slopes when short-term rates are low
Explanations
I
Long-term rates are averages of expected future short-term
rates
I
Term risk (more uncertainty with longer term)
Yield curves
Facts to explain:
I
Rates for different maturities are positively correlated over
periods of multiple years
I
Yield curves usually positively sloped
I
Yield curves have higher slopes when short-term rates are low
Explanations
I
Long-term rates are averages of expected future short-term
rates
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Term risk (more uncertainty with longer term)
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Liquidity premium