Determinants

of Asset Demand

1. Wealth
2. Expected Return
3. Risk
4. Liquidity

Asset a piece of property that is a store of value
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Determinants of Asset Demand

1. Wealth - total resources owned, including all assets

2. Expected Return - return expected over the next
period) on one asset relative to alternative assets

3. Risk - degree of uncertainty associated with the return

4. Liquidity - the ease & speed with which an asset can be
turned into cash

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Determinants of Asset Demand

Ceteris paribus -
1. Wealth - an increase in wealth raises the quantity
demanded of an asset
2. Expected Return - weighted average of all possible
returns, where the weights are the probabilities of
occurrence of that return: Re = p1R1 + p2R2 +. . . + pnRn
*an increase in an assets expected return relative to that
of an alternative asset, raises the quantity demanded of
the asset

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Determinants of Asset Demand

Ceteris paribus
3. Risk - the degree of uncertainty associated with the
return; a measure of risk called the standard deviation
(). The standard deviation of returns on an asset is
calculated as:
* Square root of the weighted squared deviations from
the expected return (Re)
= p1(R1 - Re)2 + p2(R2 - Re)2 +. . . +pn(Rn - Re)2

* if an assets risk RISES relative to that of alternative

assets, its quantity demanded will FALL
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Determinants of Asset Demand

Ceteris paribus

4. Liquidity - the ease and speed with which an asset can be

turned into cash
An asset is liquid if the market in which it is traded has
depth and breadth, i.e., if the market has many buyers
and sellers
Treasury bill - a highly liquid asset; well-organized market

* The more liquid an asset is relative to alternative

assets, the more desirable it is, and the greater will be
the quantity demanded
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Determinants of Asset Demand

Summary response:



Change in

Variable

Change in
Quantity Demanded

1. Wealth

2. Expected Return

3. Risk

4. Liquidity

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Demand & Supply Curves

Example:
1-yr Discount Bond,
Face vale, $1000

Equilibrium Pt

Holding Pd: 1 yr
Re = i = F P
P

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Demand & Supply Curves

Demand Curve Bd : downward slope, indicating that at

LOWER prices of the bond, ceteris paribus, the quantity

demanded is HIGHER

Supply Curve Bs : upward slope, indicating that as the price

increases, ceteris paribus, the quantity supplied is INCREASES

Market Equilibrium : Quantity Demanded = Quantity Supplied
Bd = Bs

or Market-Clearing Price

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Demand & Supply Curves

Market Implications
vWhen the PRICE of bonds is set too HIGH: Bs > Bd : Excess Bs
people want to SELL more bonds than others want to buy,
the price of the bonds will FALL;
as long as price is above equilibrium, it will continue to fall
vWhen the PRICE of bonds is set too LOW: Bs < Bd : Excess Bd
people want to BUY more bonds than others want to sell,
the price of the bonds will BE DRIVEN UP;
as long as price is below equilibrium, it will continue to rise

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Changes in Equilibrium Interest Rates

Movements along the Curve vs Shifts in the Curve
v ALONG the Curve:
rQty due to rPRICE or rInterest Rate (i)
v SHIFT in the Curve:
r Qty at each given PRICE or Interest Rate
- in response to r in some factors beside PRICE or i

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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds
1. Wealth
2. Expected returns on bonds relative to alternative
assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets

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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds: WEALTH

If h, h

Economy is growing rapidly,

e x p a n s i o n & w e a l t h i s
increasing, the demand curve
shifts to the RIGHT;
Recession: income & wealth
are falling, the demand for
bonds falls, and the demand
curve shifts to the LEFT.
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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds: EXPECTED RETURNS

If h, i
Higher expected interest
rates in the future i the

expected return for LT bonds,

ithe Bd, and shift the curve to
the LEFT;

Lower expected interest

rates: RIGHT.
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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds: EXPECTED INFLATION

If h, i
Higher expected ination
rates in the future i the

expected return for LT bonds,

ithe Bd, and shift the curve to
the LEFT;

Lower expected ination

rates: RIGHT.
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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds: RISK

If h, i

Increase in riskiness i the

bonds become less attractive,
ithe Bd, and shift the curve to
the LEFT;

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Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds: LIQUIDITY

If h, h

More people started trading in

the bond market, and as a result
it became easier to sell bonds
quickly; hliquidity of bonds
results in an hBd, the demand
curve shifts to the RIGHT;
hliquidity of ALTERNATIVE
ASSETS iBd, shifts the demand
curve to the LEFT.
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Changes in Equilibrium Interest Rates

Shifts in the Supply for Bonds
1. Expected protability of investment opportunities
2. Expected ination
3. Government budget

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Changes in Equilibrium Interest Rates

Shifts in the Supply for Bonds: PROFITABILITY

If h, h

Economy is growing rapidly,

business cycle expansion, Bs is
increasing, the supply curve
shifts to the RIGHT;
Recession: fewer expected
protable investment
opportunities, and the supply
curve shifts to the LEFT.
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Changes in Equilibrium Interest Rates

Shifts in the Supply for Bonds: EXPECTED INFLATION

If h, h

Real cost of borrowing i,

business cycle expansion, Bs is
increasing, the supply curve
shifts to the RIGHT
FISHER EFFECT:
When expected ination rises,
interest rates will rise
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Changes in Equilibrium Interest Rates

Shifts in the Supply for Bonds: GOVERNMENT BUDGET

If h, h

Decit: Government borrows

by issuing Treasury Bonds, Bs
is increasing, the supply curve
shifts to the RIGHT;
Surplus: supply curve shifts to
the LEFT.

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Changes in Equilibrium Interest Rates

Analysis assumptions:
1. Examine the eect of a variable change, remember that
we are assuming that all other variables are unchanged;
that is, we are making use of the ceteris paribus
assumption
2. INTEREST RATE is negatively related to the BOND PRICE,
so when the equilibrium bond price rises, the equilibrium
interest rate falls. Conversely, if the equilibrium bond
price moves downward, the equilibrium interest rate
rises.
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