- Monetary policy works primarily by manipulating interest rates. - Interest rates are determined by the demand and supply for bonds. - Demand and supply for other financial assets are determined similarly.
• Perspectives on the bond market: 1. Bonds as financial assets => Determinants of Asset Demand.
• Bond demand affected by relative risk, relative liquidity, and wealth. • Asset pricing (Finance) issues. Instantaneous responses to news.
2. Saving and Borrowing => Real Factors.
• Bond market matches savers and borrowers, affected by their behavior. • Macro issues: Real savings/investment. Takes time.
3. Liquidity Preference
• View bonds as alternative to holding money. Affected by monetary changes. • Special issues: Flexible versus “sticky” prices. DEFER.
• Application: Money & Interest Rates
• Mishkin provides survey. Needs more analysis – Start reading the lecture notes.
[Mishkin ch.5 - P.1]
Perspective #1: Bonds as Financial Assets • General Finance Question: - What determines the demand for financial assets? 1. Expected return (+) 2. Risk (-) 3. Liquidity (+) 4. Wealth (+) - Applies to all financial assets. Bonds as example. • The Demand Curve for Bonds
• Remember “High price Low yield”. Implies downward sloping demand function. • Demand function shifts if bonds’ risk or liquidity change. • Demand is relative shifts if return, risk, or liquidity on other assets change. • Note: Bond market responds quickly to financial news, to any news relevant for determining the return, risk, or liquidity of bonds relative to other assets. • Time horizon: Instantaneous (within seconds).
[Mishkin ch.5 - P.2]
Demand for other financial assets • Same arguments as for bonds:
- Downward sloping, because “higher Price lower expected return” logic applies to all financial assets, provided the asset’s payment stream remains unchanged. - Shifting down/left when risk increases.... [continues]
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