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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,2005,Pearson Education Canada Inc.,5-,*,Chapter 5,The Behaviour of Interest Rates,2005 Pearson Education Canada Inc.,Determinants of Asset Demand,2,2005,Pearson Education Canada Inc.,Derivation of Bond Demand Curve,(,F P,),i,=,RET,e,=,P,Point A:,P,=$950,($1000$950),i,=0.053=5.3%,$950,B,d,=$100 billion,3,2005,Pearson Education Canada Inc.,Derivation of Bond Demand Curve,Point B:,P,=$900,($1000$900),i,=0.111=11.1%,$900,B,d,=$200 billion,Point C:,P,=$850,i,=17.6%,B,d,=$300 billion,Point D:,P,=$800,i,=25.0%,B,d,=$400 billion,Point E:,P,=$750,i,=33.0%,B,d,=$500 billion,Demand Curve is,B,d,in Figure 1 which connects points A,B,C,D,E.,Has usual downward slope,4,2005,Pearson Education Canada Inc.,Derivation of Bond Supply Curve,Point F:,P,=$750,i,=33.0%,B,s,=$100 billion,Point G:,P,=$800,i,=25.0%,B,s,=$200 billion,Point C:,P,=$850,i,=17.6%,B,s,=$300 billion,Point H:,P,=$900,i,=11.1%,B,s,=$400 billion,Point I:,P,=$950,i,=5.3%,B,s,=$500 billion,Supply Curve is,B,s,that connects points F,G,C,H,I,and has upward slope,5,2005,Pearson Education Canada Inc.,Supply and Demand Analysis ofthe Bond Market,Market Equilibrium,1.Occurs when,B,d,=,B,s,at,P,*=$850,i,*=17.6%,2.When,P,=$950,i,=5.3%,B,s,B,d,(excess supply):,P,to,P,*,i,to,i,*,3.When,P,=$750,i,=33.0,B,d,B,s,(excess demand):,P,to,P,*,i,to,i,*,6,2005,Pearson Education Canada Inc.,Loanable Funds Terminology,1.,Demand for bonds=supply of loanable funds,2.Supply of bonds=demand for loanable funds,7,2005,Pearson Education Canada Inc.,Shifts in the Bond Demand Curve,8,2005,Pearson Education Canada Inc.,Factors that Shift the Bond Demand Curve,1.,Wealth,A.Economy grows,wealth,B,d,B,d,shifts out to right,2.Expected Return,A.,i,in future,R,e,for long-term bonds,B,d,shifts out to right,B.,e,Relative,R,e,B,d,shifts out to right,C.Expected return of other assests,B,d,B,d,shifts out to right,3.Risk,A.Risk of bonds,B,d,B,d,shifts out to right,B.Risk of other assets,B,d,B,d,shifts out to right,4.Liquidity,A.Liquidity of Bonds,B,d,B,d,shifts out to right,B.Liquidity of other assets,B,d,B,d,shifts out to right,9,2005,Pearson Education Canada Inc.,Factors that Shift Demand Curve for Bonds,10,2005,Pearson Education Canada Inc.,Shiftsinthe BondSupply Curve,1.,Profitability of InvestmentOpportunities,Businesscycleexpansion,investmentopportunities,B,s,B,s,shiftsout to right,2.ExpectedInflation,e,B,s,B,s,shiftsout to right,3.GovernmentActivities,Deficits,B,s,B,s,shiftsouttoright,2005,PearsonEducationCanadaInc.,11,FactorsthatShiftSupplyCurveforBonds,12,2005,PearsonEducationCanadaInc.,Changesin,e,:theFisherEffect,If,e,1.Relative,RET,e,B,d,shiftsintoleft,2.,B,s,B,s,shiftsouttoright,3.,P,i,2005,PearsonEducationCanadaInc.,13,EvidenceontheFisherEffect,14,2005,PearsonEducationCanadaInc.,BusinessCycleExpansion,1.,Wealth,B,d,B,d,shiftsouttoright,2.Investment,B,s,B,s,shiftsouttoright,3.If,B,s,shiftsmorethan,B,d,then,P,i,2005,PearsonEducationCanadaInc.,15,EvidenceonBusinessCyclesandInterestRates,16,2005,PearsonEducationCanadaInc.,RelationofLiquidityPreferenceFrameworktoLoanableFunds,Keynes,sMajorAssumption,TwoCategories of AssetsinWealth,Money,Bonds,1.Thus:,M,s,+,B,s,=Wealth,2.Budget Constraint:,B,d,+,M,d,=Wealth,3.Therefore:,M,s,+,B,s,=,B,d,+,M,d,4.Subtracting,M,d,and,B,s,fromboth sides:,M,s,M,d,=,B,d,B,s,Money MarketEquilibrium,5.Occurs when,M,d,=,M,s,6.Then,M,d,M,s,=0which implies that,B,d,B,s,=0,sothat,B,d,=,B,s,andbondmarketis alsoin equilibrium,17,2005,PearsonEducation CanadaInc.,1.,Equatingsupplyanddemand for bondsasin loanablefunds frameworkis equivalent toequating supplyanddemandformoney asinliquidity preferenceframework,2.Two frameworks are closely linked,but differinpracticebecauseliquidity preference assumes only two assets,moneyandbonds,andignoreseffectson interestrates from changes in expected returns on real assets,18,2005,PearsonEducation CanadaInc.,Liquidity PreferenceAnalysis,Derivation of DemandCurve,1.Keynes assumed moneyhas,i,=0,2.As,i,relative,RET,e,on money,(equivalently,opportunity costof money,),M,d,3.Demand curveformoney has usualdownwardslope,Derivation of Supplycurve,1.Assume that central bankcontrols,M,s,andit is afixed amount,2.,M,s,curve isvertical line,Market Equilibrium,1.Occurs when,M,d,=,M,s,at,i,*=15%,2.If i=25%,M,s,M,d,(excess supply):Price ofbonds,i,to,i,*=15%,3.If,i,=5%,M,d,M,s,(excess demand):Price ofbonds,i,to,i,*=15%,19,2005,Pearson Education CanadaInc.,MoneyMarket Equilibrium,20,2005,Pearson Education CanadaInc.,Risein Incomeor the Price Level,1.,Income,M,d,M,d,shifts outto right,2.,M,s,unchanged,3.,i,*rises from,i,1,to,i,2,21,2005,Pearson Education CanadaInc.,Risein Money Supply,1.,M,s,M,s,shifts outto right,2.,M,d,unchanged,3.,i,*falls from,i,1,to,i,2,22,2005,Pearson Education CanadaInc.,2005,Pearson Education CanadaInc.,23,MoneyandInterest Rates,Effects ofmoney oninterest rates,1.Liquidity Effect,M,s,M,s,shifts right,i,2.IncomeEffect,M,s,Income,
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