Lecture 5

Why do interest rates change

Demand for assets
Interest rates equilibrium
 Determinants of asset demand
• Demand for an assets is influenced by the
following factors:
1. Wealth
• When our wealth increases, we have more
resources available with which we can
purchase assets,
• Thus holding everything constant, an
increase in wealth raises the quantity
demand of an asset
 Determinants of asset demand
2. Expected return =
• When expected return on asset rises relative to
expected returns on alternative assets, holding
everything else constant, demand for that asset will
also rise
3. Risk = Standard deviation of returns
• Investors are usually risk averse and want to reduce
the uncertainty with the returns on an asset
• Hence, holding everything constant, if an asset’s risk
rises relative to that of alternative assets, its quantity
demanded will fall
 Determinants of asset demand
4. Liquidity
• Liquidity means how quickly an asset can be
converted into cash at low cost
• The more liquid an asset is to alternative
assets, holding everything else unchanged,
the more desirable it is, and the greater will
be the quantity demand.
 Supply and demand in the bond
market
• Supply and demand for bonds determine
interest rates
• Remember the following relationships:
• Interest rates and bond prices have inverse
relationships
• When interest rates rise, quantity demanded of
bonds rises and quantity supplied falls