Chapter 4 Why Do Interest Rates Change

CHAPTER :
WHY DO INTEREST RATES CHANGE?

DETERMINANTS OF ASSET DEMAND
• An asset is a piece of property that is a store of value. Items

such as money, bonds, stocks, art, land, houses, farm
equipment, and manufacturing machinery
1. Wealth, the total resources owned by the individual,
including all assets
Holding everything else constant, an increase in wealth
raises the quantity demanded of an asset
• 2. Expected return (the return expected over the next period)
on one asset relative to alternative assets
• The expected return on an asset is the weighted average of all
possible returns, where the weights are the probabilities of
occurrence of that return:
Re = p1R1 + p2R2 + g + pnRn (1)
where Re = expected return
n = number of possible outcomes (states of nature)
Ri = return in the ith state of nature
pi = probability of occurrence of the return Ri
An increase in an asset’s expected return relative to that of an
alternative asset, holding everything else unchanged, raises the
quantity demanded of the asset
• 3. Risk (the degree of uncertainty associated with the return) of one asset
relative to alternative assets
• Holding everything else constant, if an asset’s risk rises

relative to that of alternative assets, its quantity
demanded will fall.
• 4. Liquidity (the ease and speed with which an asset can be turned into
cash) relative to alternative assets
• The more liquid an asset is relative to alternative assets,

holding everything else unchanged, the more desirable
it is, and the greater will be the quantity demanded.
THEORY OF PORTFOLIO CHOICE
• Holding all the other factors constant:
1. The quantity demanded of an asset is usually 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 IN THE BOND MARKET
SHIFTS IN THE DEMAND FOR BONDS
• In a business cycle expansion with growing wealth, the demand
for bonds rises and the demand curve for bonds shifts to the right.
• In a recession, when income and wealth are falling, the demand
for bonds falls, and the demand curve shifts to the left.
• Higher expected interest rates in the future lower the expected
return for long-term bonds, decrease the demand, and shift the
demand curve to the left.
• Lower expected interest rates in the future increase the demand
for long-term bonds and shift the demand curve to the right.
• An increase in the expected rate of inflation lowers the
expected return for bonds, causing their demand to decline and
the demand curve to shift to the left.
• A decrease in the expected rate of inflation raises the expected
return for bonds, causing the demand curve to shift to the
right.
• An increase in the riskiness of bonds causes the demand for
bonds to fall and the demand curve to shift to the left.
• An increase in the riskiness of alternative assets causes the
demand for bonds to rise and the demand curve to shift to the
• Increased liquidity of bonds results in an increased
demand for bonds, and the demand curve shifts to the
right.
• Increased liquidity of alternative assets lowers the
demand for bonds and shifts the demand curve to the left.
SHIFTS IN THE SUPPLY OF BONDS
• 1. Expected profitability of investment

opportunities
• 2. Expected inflation
• 3. Government budget
• In a business cycle expansion, the supply of bonds
increases, and the supply curve shifts to the right.
• In a recession, when far fewer profitable investment
opportunities are expected, the supply of bonds falls, and
the supply curve shifts to the left.
• An increase in expected inflation causes the supply of
bonds to increase and the supply curve to shift to the right.
• A decrease in expected inflation causes the supply of
bonds to decrease and the supply curve shifts to the left.
• Higher government deficits increase the supply
of bonds and shift the supply curve to the right.
• Government surpluses decrease the supply of
bonds and shift the supply curve to the left.

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CHAPTER :

WHY DO INTEREST RATES CHANGE?

• An asset is a piece of property that is a store of value. Items

• Holding everything else constant, if an asset’s risk rises

• The more liquid an asset is relative to alternative assets,

• 1. Expected profitability of investment

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