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Demand for an Asset. Wealth Expected return…relative to alternative assets Risk —uncertainty of return—relative to alternative assets Liquidity —ease and speed an asset can be turned into cash—relative to alternative assets. Shifts in the Demand for Money. Income Effect:

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Demand for an Asset

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Demand for an asset l.jpg

Demand for an Asset

  • Wealth

  • Expected return…relative to alternative assets

  • Risk—uncertainty of return—relative to alternative assets

  • Liquidity—ease and speed an asset can be turned into cash—relative to alternative assets


Shifts in the demand for money l.jpg

Shifts in the Demand for Money

  • Income Effect:

    • Higher income  more stuff bought  demand for money at each interest rate increases

  • Price-Level Effect:

    • Rise in the price level  need more money to buy the same amount of stuff  the demand for money at each interest rate increases

  • Monetary Base: Controlled by Fed

  • Money Multiplier: (1 + c)/(c + r + e)

  • We’ll assume Ms controlled by Fed

  • Shifts in the Supply of Money


    Interest rate and the money supply l.jpg

    Interest Rate and the Money Supply

    • Liquidity effect: Ms up lowers interest rates

      But Ms up also increases output and prices

    • Income effect: Ms up  increased output  increased demand for money  interest rate up

    • Price-Level effect: Ms up  increased price level  increased demand for money  interest rate up

    • Expected-Inflation effect: Ms up  expectation of ongoing inflation (maybe) interest rate up

      Since i = r + πe, if π and πecatches up as it must, i too

      Since (M/P)d = L(Y,i) is stable at each Y, (M/P)smust fall when π . P must rise faster than M.


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    4.2 You have just won $10 million , $1 every year for the next 10 years. Discuss.

    4.6 What is the yield to maturity of a $1,000 face value discount bond that matures in 1 year and sells for $800? What if it matured in 2 years?

    4.12 If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Which type of bond has greater interest rate risk?

    4.19 Interest rates were lower in the mid-1980s than they were in the late 1970s,

    Yet many economists say that real interest rates were actually much higher

    in the mid-1980s. Does this make sense?

    5.6 An important way in which the Fed decreases M s is by selling bonds to the public. Using a supply and demand analysis for bonds, show the effect on i.

    Using the liquidity preference framework, show the effect on i.

    5.17. The Chairman of the Fed announces that interest rates will rise sharply next year. What will happen to corporate bond interest rates today? Explain.


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