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Topics: Supply and demand, Inflation, Economic equilibrium Pages: 8 (2948 words) Published: May 24, 2014
Chapter 4
Why Do Interest Rates Change?
Determinants of Asset Demand
Wealth
Expected Returns
Risk
Liquidity
Summary
Supply and Demand in the Bond Market
Demand Curve
Supply Curve
Market Equilibrium
Supply and Demand Analysis
Loanable Funds Framework
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
Shifts in the Supply of Bonds
Case: Changes in the Equilibrium Interest Rate Due to Expected Inflation Or Business Cycle Expansions
Case: Explaining Low Japanese Interest Rates
Case: Reading the Wall Street Journal: The “Credit Markets” Column The Wall Street Journa l: Following the News: The “Credit Markets” Column The Practicing Financial Institutions Manager: Profiting from Interest-Rate Forecasts The Wall Street Journal: Following the News: Forecasting Interest Rates Appendix 1: Models of Asset Pricing

Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Appendix 3: Supply and Demand in the Market for Money: The Liquidity Preference Framework

T Overview and Teaching Tips
As is clear in the Preface to the textbook, I believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined, how financial institutions manage their assets and liabilities, why financial innovation takes place, how prices are determined in the stock market and the foreign exchange market.

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Part 2

Fundamentals of Financial Markets

One teaching device that I have found helps students develop their intuition is the use of summary tables, such as Table 1, in class. I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout my course and in this book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly.

The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market). A second approach, the liquidity preference framework (supply and demand in the money market) is now covered in appendix 3, which is available on the web. As is made clear there, this second approach is consistent with the other but provides another useful way of looking at the same thing.

An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using a stock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with modern treatment of asset markets by financial economists.

Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principles of economics...
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