Asset Demand: Arguments For and Against

This sample essay on Asset Demand provides important aspects of the issue and arguments for and against as well as the needed facts. Read on this essay’s introduction, body paragraphs, and conclusion.

Demand and Supply for Financial Assets Mishkin ch. 5: Bonds
• Motivation: – Monetary policy works primarily by manipulating interest rates. – Interest rates are determined by the demand and supply for bonds. – Demand and supply for other financial assets are determined similarly.
• Perspectives on the bond market: 1. Bonds as financial assets => Determinants of Asset Demand.

• Bond demand affected by relative risk, relative liquidity, and wealth.
• Asset pricing (Finance) issues. Instantaneous responses to news. 2. Saving and Borrowing => Real Factors. Bond market matches savers and borrowers, affected by their behavior.
• Macro issues: Real savings/investment. Takes time. 3. Liquidity Preference
• View bonds as alternative to holding money. Affected by monetary changes.
• Special issues: Flexible versus “sticky” prices. DEFER.
• Application: Money & Interest Rates
• Mishkin provides survey. Needs more analysis – Start reading the lecture notes.

[Mishkin ch. 5 – P. 1] Perspective #1: Bonds as Financial Assets
• General Finance Question: – What determines the demand for financial assets? . Expected return (+) 2. Risk (-) 3. Liquidity (+) 4. Wealth (+) – Applies to all financial assets. Bonds as example.
• The Demand Curve for Bonds
• Remember “High price Low yield”. Implies downward sloping demand function.
• Demand function shifts if bonds’ risk or liquidity change.
• Demand is relative shifts if return, risk, or liquidity on other assets change.
• Note: Bond market responds quickly to financial news, to any news relevant for determining the return, risk, or liquidity of bonds relative to other assets.

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Time horizon: Instantaneous (within seconds). [Mishkin ch. 5 – P. 2] Demand for other financial assets
• Same arguments as for bonds: – Downward sloping, because “higher Price lower expected return” logic applies to all financial assets, provided the asset’s payment stream remains unchanged. – Shifting down/left when risk increases. Shifting up/right when liquidity increases. Examples: Stocks, mutual funds, real estate, gold, investments abroad. Similar for equity-type assets, except future payments are uncertain – New element: Unexpected new information about payments shift the demand curve
• Example: Stock with expected value next year $100 – More demand now at $80 than at $90 => Downward sloping demand curve. – Suppose the expected value next year rises to $120: Demand at $96 (20% discount) is similar to previous demand at $80 => Shift right/up in the demand curve
• Special factor for long-term bonds: – Rising interest rate before maturity would reduce the price => Reduce the return => Expected increases in interest rates reduce the demand for long-term bonds. Mishkin ch. 5 – P. 3] Wealth as Demand Factor: Caution
• Basic point: More wealth => More demand for all financial assets.
• Contrast wealth with the demand factors that affect relative values: – Demands for different financial assets are negatively related when relative returns, relative risks, and relative liquidity levels shift. – Demands for different financial assets are positive related when wealth changes.
• Wealth can change in two ways: 1. New savings. 2. Re-valuation. – Re-valuation is a distraction (or even misleading): Not a source of new demand.

Example: Hold 100 bonds @100 = $10,000 wealth. If price rises to $110 => Wealth $11,000. Will demand increase? Demand from existing wealth is still 100 bonds. – New savings must come from real activity = Surplus of income over spending. – New savings take time: NOT an instantaneous factor => Creates dynamics. – Purchasing power of wealth is eroded by inflation => Real returns (after inflation) determine the incentives to save
• Lessons for applications: – Source of wealth changes is savings. Savings raise all asset demands. Quantity axis in diagrams = Number of securities or their face value (not $ value). [Mishkin ch. 5 – P. 4] The supply of bonds and other financial assets
• Simple: the supplier/issues of securities defines the market! – Treasury bond market = supply by U. S. Treasury – Market for Microsoft stock = supply by Microsoft
• Supply incentives in the primary market: 1. Need for funds: – Private: Profitability of capital investments. – Public: Level of government budget deficits. 2. Cost of borrowing: – Borrow more if the cost is low => upward-sloping supply curve. Inflation reduces the real value of debt => Real returns (after inflation) determine the incentives to issue securities
• Secondary market: Fixed supply except for buyback/new issues. => Steep or vertical supply curve.
• Mishkin’s demand & supply diagrams: generic up/down slopes [Mishkin ch. 5 – P. 5] Demand & Supply => Equilibrium Price and Volume
• For bonds: Exact price-yield relationship (Example: F=1000)
• For all financial assets: High price tends to imply low future returns. [Mishkin ch. 5 – P. 6]

Asset Demand

Applications: Predict the Effect of Changes
• Reasons why bond demand may shift
• Reasons why bond supply may shift
• Scenarios that involve shifts in demand and supply: – Business cycles – Inflation: The Fisher Effect
• In each case: – Task: Determine the impact on prices and quantities. – Ask additional questions: What’s the time horizon? What’s the likely impact on other markets, e. g. , the stock market?
• Alternative view: Loanable Funds analysis (see Online Appendix5#1) – Supply of securities = Demand for financing – Demand for securities = Supply of funds to financial markets. > Helpful way to think about markets, but not required for exams. [Mishkin ch. 5 – P. 7] Summary: Factors that shift the Demand for Bonds [Mishkin ch. 5 – P. 8] Summary: Factors that shift the Supply for Bonds [Mishkin ch. 5 – P. 9] Notes on Mishkin’s Examples (1)
• About higher expected interest rates: – Higher yield expected => Lower expected return => Decline in demand => Reduced price => Yield rises immediately. – Lesson: Rational investors act on expectations. Markets move when information arrives that changes investor expectations. About the slopes of demand and supply curves: – Demand: Depends on how easily investors can go elsewhere when prices rise: – For a specific bond relative to others: Essentially horizontal/very flat. – For bonds as an asset class: Elastic/flat. Investors can substitute to stocks etc. – For bonds as reflecting the supply of savings: Quite inelastic/steep. Consumptionsavings decisions are not highly sensitive to interest rates. – Supply: usually inelastic/steep. New issues are small relative to outstanding quanties of identical or similar securities. Relevance of slopes: Steeper vs. flatter Larger vs. smaller price changes. [Exam: Generic slopes okay. But remember for real-world applications. ] [Mishkin ch. 5 – P. 10] Notes on Mishkin’s Examples (2)
• About the time horizon and level of aggregation: – Instructive to separate two sets of issues: 1. Allocation of existing financial assets: – Instantaneous: Supply is well-approximated by a vertical line. – Pricing is relative to other financial assets. – Economic arguments involve relative return, risk, liquidity (nothing else). In equilibrium, all financial assets must attract investors => Must offer the same risk- and liquidity-adjusted return. 2. Flows of savings and capital investment: – Takes time: New demand and supply more important relative to existing financial assets the more time passes. – Savings are unspecific: Savers will invest in any savings vehicles that pays the equilibrium return: Markets clear at the aggregate level. – Equilibrium return must match aggregate flow of funds into financial markets with total demand for funds from issuers of securities. [Mishkin ch. 5 – P. 11]

Scenario: Business Cycle Expansion
• Shifts in Demand and Supply: Higher incomes. Real capital investment is more profitable. [Caution: Distinguish real and financial investments! ]
• Questions: What causes business cycles? How do we know that supply shifts more than demand? => Macroeconomic issues. [Mishkin ch. 5 – P. 12] Scenario: Increase in Expected Inflation
• Lower real cost of borrowing => More security issues (supply).
• Lower real return => Less savings (demand). Conclude: Fisher effect.
• Questions: What causes higher expected inflation? => Macroeconomic issue. Mishkin ch. 5 – P. 13] Evidence on the Fisher Effect (Fits the data – at least in the long-run) [Mishkin ch. 5 – P. 14] Collect Open Questions
• Why does expected inflation change? – Leading answer: Money growth. Not an exogenous disturbance. => Needs analysis. Topic: Money and Inflation.
• What causes business cycles? – Many causes. Among them: “Mistakes” in monetary policy. => Needs analysis. Topic: Money and Output.
• Agenda: 1. Reinforce the lessons on demand and supply: More examples. 2. Examine how monetary policy influences inflation and output. 3.

Return to the interest rates – remainder of Mishkin ch. 5 [Mishkin ch. 5 – P. 15] Applications of Asset Demand & Supply Analysis 1. A Classic: The “Flight to Quality” (Lesson: Asset demand is relative) Stock Market Price Supply Price Bond Market Supply Demand Stocks Demand Bonds 1987 stock market crash: stocks -> flight to bonds 1994 Mexican Peso crisis: emerging market stocks -> to US stocks and bonds 1997 Asian crisis: Asian stocks and bonds -> to US and Europeans stocks and bonds 1998 Russian default: risky bonds (foreign and US low quality) -> to US Treasury bonds . The Term Structure of interest rates: (Mishkin ch. 6, part 2) – Defer discussion, raises macro issues. [Mishkin ch. 5 – P. 16] 3. The Risk-structure of interest rates: (Mishkin ch. 6, part 1) – Good measures of riskiness: Bond Ratings – Good measures of promised return: Yield to maturity. – Find: (1) Changes in risk => Changes in relative yields (2) Holding risk constant, yields move together 4. The Stock Market Crash of 1987 – Can we always assume that demand is downward sloping? . The Market for Foreign Exchange (Mishkin ch. 17. Much improved in 8ed. ) – Exchange rate = Relative price of different country’s financial assets – Demand = Function of relative return, risk, and liquidity – Supply = Fixed in short run (apart from official interventions – later) – More later if time – for now, note one key point: High US interest rates relative to foreign interest rates increase the demand for dollar assets => Stronger dollar [Mishkin ch. 5 – P. 17]