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

Interest Rate Determination: Supply and Demand for Bonds At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship Market equilibrium— the price where the quantity people are willing to buy equals the quantity people are willing to sell

Interest Rate Determination: Supply and Demand for Money : : Liquidity Preference Framework

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 M s controlled by Fed Shifts in the Supply of Money

Interest Rate and the Money Supply Liquidity effect: M s up lowers interest rates But M s up also increases output and prices Income effect: M s up  increased output  increased demand for money  interest rate up Price-Level effect: M s up  increased price level  increased demand for money  interest rate up Expected-Inflation effect: M s up  expectation of ongoing inflation (maybe)  interest rate up

Price-Level Effect and Expected-Inflation Effect A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices. Price-level effect remains even after prices have stopped rising. A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero. Expected-inflation effect persists only as long as the price level continues to rise.