Demand and Supply for Financial Assets

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Demand and Supply for Financial Assets Mishkin ch.5: Bonds • Motivation: - 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. Shifting up/right when liquidity increases. Examples: Stocks, mutual funds, real estate, gold, investments abroad.

• Similar for equity-type assets, except future payments are uncertain - New element: Unexpected new information about payments shift the demand curve • Example: Stock with expected value next year $100 - More demand now at $80 than at $90 => Downward sloping demand curve. - Suppose the expected value next year rises to $120: Demand at $96 (20% discount) is similar to previous demand at $80 => Shift right/up in the demand curve

• Special factor for long-term bonds:
- Rising interest rate before maturity would reduce the price => Reduce the return => Expected increases in interest rates reduce the demand for long-term bonds.

[Mishkin ch.5 - P.3]

Wealth as Demand Factor: Caution • Basic point: More wealth => More demand for all financial assets. • Contrast wealth with the demand factors that affect relative values: - Demands for different financial assets are negatively related when relative returns, relative risks, and relative liquidity levels shift. - Demands for different financial assets are positive related when wealth changes.

• Wealth can change in two ways: 1. New savings. 2. Re-valuation. - Re-valuation is a distraction (or even misleading): Not a source of new demand. Example: Hold 100 bonds @100 = $10,000 wealth. If price rises to $110 => Wealth $11,000. Will demand increase? Demand from existing wealth is still 100 bonds.

- New savings must come from real activity = Surplus of income over spending. - New savings take time: NOT an instantaneous factor => Creates dynamics. - Purchasing power of wealth is eroded by inflation => Real returns (after inflation) determine the incentives to save • Lessons for applications: - Source of wealth changes is savings. Savings raise all asset demands. - Quantity axis in diagrams = Number of securities or their face value (not $ value).

[Mishkin ch.5 - P.4]

The supply of bonds and...
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