Behavior of Interest RatesDeterminants of Asset Demand Wealth: the total resources owned by the individual, including all assets (accumulated) Expected Return: return expected on an asset relative to alternative asset (utility) Risk: degree of uncertainty on expected return Liquidity: the ease and speed of turning assets into cashSupply and Demand in the Bond Market Lower prices, higher quantity demanded Lower prices, lower quantity suppliedChanges in Equilibrium Interest Rates Liquidity = higher liquidity means lower transaction costsShifts in the Demand of Bonds Wealth: High wealth = High demand Expected interest rate: high EIR = Low demand Expected inflation: high inflation = low demand Risk: high risk = low demand Liquidity: high liquidity = high demandShifts in the Supply of Bonds Profitability of investments: High = High supply Expected inflation: higher inflation = higher supply: suppliers will pay less in the future Government deficit: high = high supplyThe Liquidity Preference Framework There are two categories of asset wherein people store their wealth: money and bondsShifts in demand of moneyIncome Effect As an economy and income rises, wealth increases and people want to hold more money As an economy and income rises, people would want to transact more A higher level of income causes demand and supply for money at each interest rate to increase; interest rate increasesPrice-Level Effect When the price level rises, the same nominal quantity of money is no longer enough to purchase real goods; interest rate increases A rise in the price level causes demand and supply for money at each interest rate to increase; interest rate increasesMoney Supply A rise in money supply causes increase in money demand and supply; interest rate decreases