Equilibrium in the money market

[rinishj28]

1. The surplus balances due to interest rates above equilibrium level would result in people buying more of shares and bonds and other assets. Why?

2. Due to higher demand of shares, bonds etc. Prices rise and interest rates on these assets fall

How are the bank interest rates and the interest rates on these assets (which I'm assuming to be the coupons) related?

Thank You

 

[Graham Aylott]

If people have surplus cash balances (ie more than they need for transactions and precautionary purposes), then they will "save" that money to fund future purchases. One important way of doing this is by buying shares and bonds.

The future cashflows (dividends) you receive from a share are independent of the price you initially pay for the share. For fixed-interest bonds, the coupons you receive are fixed and therefore entirely independent of the price you pay for the bond. So, the higher price you pay for the share or bond, the lower is the rate of return (or yield) you subsequently receive.

The textbook suggests (without proof) that interest on cash and the returns (yields) on assets such as shares and bonds "tend to move together", ie they are positively correlated.

 

[cjno1]

Think of it in terms of risk and return. If you invest in cash that's generally thought to be very safe, so has a lower return. If you invest in bonds then those are more risky, so you get a "risk premium", a higher yield to compensate for this risk. Equities are riskier still, and so have a higher risk premium.

This means that if the interest rate on cash increases you would expect (assuming the size of these risk premiums doesn't change) that the yield on bonds and equities should increase proportionally.

This isn't necessarily true, but in theory that's how it should work.