The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9780132770248

10th Edition

610 Questions

33,211 Students Helped

Homework Questions

Summary

Learning Objectives

Key Concepts

Example Problems

Explanations

Common Mistakes

Summary

This chapter section explores the determinants of asset demand and their effect on interest rates. It highlights how wealth, expected return, risk, and liquidity shape asset demand in the bond and money markets. The supply and demand framework reveals the inverse relationship between bond prices and interest rates, while the liquidity preference model explains the impact of monetary factors and economic conditions. Additionally, the Fisher effect links nominal interest rates to expected inflation, with real-world examples, such as the situation in Japan, illustrating these concepts in practice.

Learning Objectives

Explain how factors such as wealth, expected return, risk, and liquidity influence the demand for assets.

Analyze the role of the supply and demand framework in determining equilibrium interest rates in the bond market.

Describe the liquidity preference framework and how changes in the money supply, income, and price levels impact interest rates.

Understand the Fisher effect and the relationship between expected inflation and nominal interest rates.

Key Concepts

CONCEPT

DEFINITION

Asset Demand

The desire to hold financial assets, influenced by factors like wealth, expected return, risk, and liquidity.

Equilibrium Interest Rate

The interest rate at which the quantity of bonds (or money) demanded equals the quantity supplied.

Supply and Demand Framework (Bonds)

A model showing that lower bond prices correspond to higher interest rates and vice versa, balancing supply and demand in the bond market.

Liquidity Preference Framework

A theory developed by Keynes that explains how changes in money supply, income, and price levels affect interest rates through individuals' demand for liquidity.

Fisher Effect

The relationship between expected inflation and nominal interest rates, indicating that nominal rates tend to adjust with changes in expected inflation.

Example Problems

Example 1

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: a. Your wealth falls. b. You expect the stock to appreciate in value. c. The bond market becomes more liquid. d. You expect gold to appreciate in value. e. Prices in the bond market become more volatile.

Example 2

Explain why you would be more or less willing to buy a house under the following circumstances: a. You just inherited $\$ 100,000$. b. Real estate commissions fall from $6 \%$ of the sales price to $5 \%$ of the sales price. c. You expect Microsoft stock to double in value next year d. Prices in the stock market become more volatile. e. You expect housing prices to fall.

Example 3

Explain why you would be more or less willing to buy gold under the following circumstances: a. Gold again becomes acceptable as a medium of exchange. b. Prices in the gold market become more volatile. c. You expect inflation to rise, and gold prices tend to move with the aggregate price level. d. You expect interest rates to rise.

Example 4

Explain why you would be more or less willing to buy long-term AT\&T bonds under the following circumstances: a. Trading in these bonds increases, making them easier to sell. b. You expect a bear market in stocks (stock prices are expected to decline). c. Brokerage commissions on stocks fall. d. You expect interest rates to rise. e. Brokerage commissions on bonds fall.

Example 5

What would happen to the demand for Rembrandt paintings if the stock market undergoes a boom? Why?

Step-by-Step Explanations

QUESTION

How do bond prices and interest rates interact in the supply and demand framework?

STEP-BY-STEP ANSWER:

Step 1: Recognize that in the bond market, demand and supply determine the price of bonds.
Step 2: Understand that there is an inverse relationship between bond prices and interest rates; as bond prices fall, interest rates rise.
Step 3: Identify the equilibrium where the quantity of bonds demanded equals the quantity supplied, thereby setting the market interest rate.
Final Answer: The bond market reaches an equilibrium interest rate when the lower bond prices (indicating higher yields) balance investor demand with the available supply.

Supply and Demand Framework for Bonds

QUESTION

How do changes in the money supply, income, and price levels impact interest rates according to the liquidity preference framework?

STEP-BY-STEP ANSWER:

Step 1: Understand that according to Keynes, individuals demand money for transaction and precautionary purposes, creating a preference for liquidity.
Step 2: Recognize that an increase in the money supply, holding other factors constant, reduces the demand for liquid assets, thereby lowering interest rates.
Step 3: Factor in that higher income and higher price levels can increase the demand for money, potentially driving interest rates upward.
Final Answer: The liquidity preference framework demonstrates that interest rates are determined by balancing the supply of money with the demand for liquidity, influenced by changes in money supply, income, and prices.

Liquidity Preference Framework

QUESTION

What is the Fisher effect and how does it link expected inflation to nominal interest rates?

STEP-BY-STEP ANSWER:

Step 1: Identify that the Fisher effect relates nominal interest rates to expected inflation rates.
Step 2: Recognize that as expected inflation increases, nominal interest rates typically rise to maintain real returns for investors.
Step 3: Understand that this adjustment helps preserve the purchasing power of interest income in an inflationary environment.
Final Answer: The Fisher effect explains that nominal interest rates adjust upward with increases in expected inflation to ensure that the real, inflation-adjusted return remains stable.

Fisher Effect

Common Mistakes

Confusing the inverse relationship between bond prices and interest rates, mistakenly believing that higher bond prices lead to higher interest rates.
Overlooking the role of liquidity preferences, such as the impact of income and price levels on interest rates.
Failing to differentiate between nominal and real interest rates when considering the implications of the Fisher effect.
Assuming that changes in one factor (e.g., wealth) automatically translate into equivalent changes in asset demand without considering risk and liquidity factors.