Chapter 4Why Do Interest Rates Change?21Chapter 4Why Do Interest Rates Change?Determinants of Asset DemandWealthExpected ReturnsRiskLiquiditySummarySupply and Demand in the Bond MarketDemand CurveSupply CurveMarket EquilibriumSupply and Demand AnalysisChanges in Equilibrium Interest RatesShifts in the Demand for BondsShifts in the Supply of BondsCase: Changes in the Equilibrium Interest Rate Due to Expected Inflation: The Fisher EffectCase: Changes in the Interest Rate Due to a Business Cycle ExpansionCase: Explaining Low Japanese Interest RatesCase: Reading the Wall Street Journal: The “Credit Markets” ColumnThe Wall Street Journal: Following the News: The “Credit Markets” ColumnThe Practicing Manager: Profiting from Interest-Rate ForecastsThe Wall Street Journal: Following the News: Forecasting Interest RatesAppendix 1: Models of Asset PricingAppendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of GoldAppendix 3: Loanable Funds FrameworkAppendix 4: Supply and Demand in the Market for Money: The Liquidity Preference FrameworknOverview and Teaching TipsAs is clear in the Preface to the textbook, I believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence peoples decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined, how financial institutions manage their assets and liabilities, why financial innovation takes place, how prices are determined in the stock market and the foreign exchange market.One teaching device that I have found helps students develop their intuition is the use of summary tables, such as Table 1, in class. I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout my course and in this book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly.The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market. An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using a stock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with modern treatment of asset markets by financial economists.Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principles of economics textbooks. The ceteris paribus derivations of supply and demand curves with numerical examples are presented, the concept of equilibrium is carefully developed, the factors that shift the supply and demand curves are outlined, and the distinction between movements along a demand or supply curve and shifts in the curve is clearly drawn. My feeling is that the step-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of financial markets and institutions. I have found that even those students who have had excellent training in earlier courses find that this chapter provides a valuable review of supply and demand analysis.An additional innovative feature of the book that first appears in this chapter are the special applications, “Case: the Wall Street Journal.” These cases show students how the analytical framework in the book can be used directly to understand the daily columns in the United States leading financial newspaper. The students particularly like the case on reading the credit markets column because it shows them that the concepts developed in the chapter are actually used in the real world. In teaching my class, I