Behavior of Interest Rates

Determinants of Asset Demand

Wealth: the total resources owned by the individual,
including all assets (accumulated)
Expected Return: return expected on an asset relative
to alternative asset (utility)
Risk: degree of uncertainty on expected return
Liquidity: the ease and speed of turning assets into
cash
Supply and Demand in the Bond Market
Lower prices, higher quantity demanded
Lower prices, lower quantity supplied
Changes in Equilibrium Interest Rates
Liquidity = higher liquidity means lower transaction
costs
Shifts in the Demand of Bonds

Wealth: High wealth = High demand

Expected interest rate: high EIR = Low demand
Expected inflation: high inflation = low demand
Risk: high risk = low demand
Liquidity: high liquidity = high demand

Shifts in the Supply of Bonds

Profitability of investments: High = High supply
Expected inflation: higher inflation = higher supply:
suppliers will pay less in the future
Government deficit: high = high supply
The Liquidity Preference Framework
There are two categories of asset wherein people store
their wealth: money and bonds

Shifts in demand of money

Income Effect
As an economy and income rises, wealth increases and
people want to hold more money
As an economy and income rises, people would want to
transact more
A higher level of income causes demand and supply for
money at each interest rate to increase; interest rate
increases
Price-Level Effect
When the price level rises, the same nominal quantity
of money is no longer enough to purchase real goods;
interest rate increases
A rise in the price level causes demand and supply for
money at each interest rate to increase; interest rate
increases
Money Supply
A rise in money supply causes increase in money
demand and supply; interest rate decreases