Increasing Information Available to Investors

Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient
operation of financial markets. Risky firms or outright crooks may be the most eager to sell securities to unwary investors, and the resulting adverse selection
problem may keep investors out of financial markets. Furthermore, once an investor has bought a security, thereby lending money to a firm, the borrower may
have incentives to engage in risky activities or to commit outright fraud. The presence of this moral hazard problem may also keep investors away from financial
markets. Government regulation can reduce adverse selec- tion and moral hazard problems in financial markets and enhance the efficiency of the markets by
increasing the amount of information available to investors.
Provincial securities commissions, the most significant being the Ontario Securities Commission (OSC), administer provincial Acts requiring corporations issuing
securities to disclose certain information about their sales, assets, and earnings to the public and restrict trading by the largest stockholders in the corporation. By
requiring disclosure of this information and by discouraging insider trading, which could be used to manipu- late securities prices, regulators hope that investors
will be better informed and better protected from abuses in financial markets. Indeed, in recent years, the OSC has been particularly active in prosecuting people
involved in insider trading in Canada’s largest stock exchange, the Toronto Stock Exchange.
Ensuring the Soundness of Financial Intermediaries
Asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as a financial panic. Because providers of funds to financial
intermediaries may not be able to assess whether the institutions holding their funds are sound, if they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both sound and unsound institutions. The possible outcome is a financial panic that produces large losses
for the public and causes serious damage to the economy. To protect the public and the economy from financial panics, the govern- ment has implemented five
types of regulations.
Restrictions on Entry Provincial banking and insurance commissions, the Bank of Canada, and the Office of the Superintendent of Financial Institutions
(OSFI), an agency of the federal government, have created tight regulations governing who is allowed to set up a financial intermediary. Individuals or groups that
want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the provincial or federal government. Only if they
are upstanding corporate citizens with impeccable credentials and a large amount of initial funds will they be given a charter.
Disclosure Reporting requirements for financial intermediaries are stringent. Their bookkeeping must follow certain strict principles; their books are subject to
periodic inspection; and they must make certain information available to the public.
Restrictions on Assets and Activities Financial intermediaries are restricted in what they are allowed to do and what assets they can hold. Before you put your
funds into a chartered bank or some other such institution, you would want to know that your funds are safe and that the financial intermediary will be able to meet
its obligations to you. One way of doing this is to restrict the financial intermediary from engaging in certain risky activities. Another way to limit a financial
intermediary’s behaviour is to restrict it from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent. For
example, chartered banks and other deposi- tory institutions are not allowed to hold common stock because stock prices experience substantial fluctuations.
Insurance companies are allowed to hold common stock, but their holdings cannot exceed a certain fraction of their total assets.
Deposit Insurance The government can insure people’s deposits so that they do not suffer any financial loss if the financial intermediary that holds these
deposits fails. The most important government agency that provides this type of insurance is the Canada Deposit Insurance Corporation (CDIC), created by an act
of Parliament in 1967. It in- sures each depositor at a member deposit-taking financial institution up to a loss of $100 000 per account. Except for certain wholesale
branches of foreign banks, credit unions, and some provincial institutions, all deposit-taking financial institutions in Canada are members of the CDIC. All CDIC
members make contributions into the CDIC fund, which are used to pay off depositors in the case of a bank’s failure. The Québec Deposit Insurance Board, an
organization similar to the CDIC and set up at the same time as the CDIC, provides insurance for Trust and Mortgage Loan Companies (TMLs) and credit
cooperatives in Québec.
Limits on Competition Politicians have often declared that unbridled competition among financial intermediaries promotes failures that will harm the public.
Although the evidence that competition has this effect is extremely weak, provincial and federal governments at times have imposed restrictive regulations. For
example, from 1967 to 1980 the entry of foreign banks into the Canadian banking industry was prohib- ited. Since 1980, however, the incorporation of foreign
bank subsidiaries has been regulated, but Canada still ranks low with respect to the degree of competition from foreign banks. =
Financial Regulation Abroad
Not surprisingly, given the similarity of the economic systems here and in the United States, Japan, and the nations of Western Europe, financial regulation in
those countries is similar to that of Canada’s. The provision of information is improved by requiring corporations issuing securities to report details about assets
and liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness of intermediaries is ensured by licensing, periodic inspection of
financial intermediaries’ books, and the provision of deposit insurance.
The major differences between financial regulation in Canada and abroad relate to bank regulation. In the past, for example, the United States was the only
industrial- ized country to subject banks to restrictions on branching, which limited banks’ size and restricted them to certain geographic regions. These restrictions
were abolished by legislation in 1994. U.S. and Canadian banks are also highly restrictive in the range of assets they may hold. Banks in other countries frequently

hold shares in commercial firms; in Japan and Germany, those stakes can be sizable.
Wealth
When wealth increases, more resources to purchase assets are available, and so, the quantity of assets we demand increases.
- Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.

Expected Returns
The return on an asset (e.g., bond) measures how much we gain from holding that asset. When we decide to buy an asset, we are
influenced by what we expect the return on that asset to be.
E.g., If a Bond has a return of 15% half time and 5% the other half, its expected return (avg. return) is 10 %=0.5∗15 %+ 0.5∗5 % 2. If
the expected return on the bond rises relative to expected returns on alternative assets, then, holding everything else constant, it
becomes more desirable to purchase the bond, and the quantity demanded increases.
This can occur in either of two ways: (1) when the expected return on the bond rises while the return on an alternative asse t, stock,
remains unchanged or (2) when the return on the alternative asset, stock, falls while the return on bond remains unchanged.
- An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises
the quantity demanded of the asset.

Risk
The degree of risk or uncertainty of an asset’s returns also affects demand for the asset.
Consider two assets: stock A and stock B. Stock A has a return of 15% half the time and 5% the other half, making its expected return
10%, while stock B has a fixed return of 10%. Stock A has uncertainty associated with its returns and so has greater risk than stock
B, whose return is a sure thing. A risk-averse person prefers stock in B (the sure thing) to A (the riskier asset), even though they
have the same expected return: 10%. Most people are risk-averse, especially in financial decisions: Everything else being equal, they
prefer to hold the less risky asset. A person who prefers risk is a risk preferer or risk lover.
- Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.

Liquidity (how quickly it can be converted into cash at low costs)

An asset is liquid if the market in which it is traded has depth and breadth– it has many buyers & sellers. House is not a very liquid
asset as it is hard to find a buyer quickly; if house must be sold to pay off bills, it might be sold for a much lower price. And
transaction costs associated with selling a house (broker’s commissions, lawyer’s fees…) are substantial. A Canadian govt. Treasury
bill is a highly liquid asset. It can be sold in a well-organized market with many buyers; thus can be sold quickly at low cost.
- The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is and
the greater the quantity demanded will be

Wealth
When the economy is growing rapidly in a business cycle expansion, and wealth is increasing, the
quantity of bonds demanded at each bond price (or interest rate) increases. With greater wealth, quantity
of bonds demanded at the same price must rise; initial demand curve Bd1 shifts right to Bd2 (indicated by
arrows).
- In a business cycle expansion with growing wealth, demand for bonds rises and demand curve for
bonds shifts to the right.
- In a recession, income and wealth are falling, demand for bonds falls, and demand curve shifts
left.
The public’s propensity to save also affects wealth.
 If households save more, wealth increases; demand for bonds rises; demand curve (bonds) shifts to
right.
 If people save less, wealth and the demand for bonds fall, and the demand curve shifts to the left.

Expected Interest Rates/Return

i. For a one-year discount bond and a one-year holding period, the expected return and the interest rate
are identical, so nothing other than today’s interest rate affects the expected return.
ii. For bonds with maturities greater than one year, the expected return may differ from the interest rate.
E.g., A rise in the interest rate on a long-term bond from 10% to 20% would lead to a sharp decline in
price and a very large negative return.
a. Hence, if people expect interest rates to be higher next year than they originally anticipated, expected
return today on long-term bonds would fall and quantity demanded would fall at each interest rate.
- Higher expected future interest rates lower the expected return for long- term bonds, decrease the
demand, and shift the demand curve to the left.
b. If people expect lower future interest rates, long- term bond prices would be expected to rise more
than originally anticipated, and the resulting higher expected return today would raise the quantity
demanded at each bond price and interest rate.
- Lower expected future interest rates increase the demand for long-term bonds and shift the
demand curve to the right.
-
Changes in expected returns on other assets shifts the demand curve for bonds.
If people become more optimistic about the stock market and expect higher stock prices in future, both expected
capital gains and expected returns on stocks will rise. With expected return on bonds held constant, expected return
on bonds today relative to stocks will fall, lowering the demand for bonds and shifting demand curve to the left.
- An increase in expected return on alternative assets lowers the demand for bonds and shifts the demand
curve to the left.

Expected Inflation
A change in expected inflation is likely to alter expected returns on physical assets (real assets)— automobiles,
houses, which affect the demand for bonds.
E.g., An increase in expected inflation from 5% to 10% will lead to higher prices on cars and houses in the future
and hence higher nominal capital gains. The resulting rise in the expected returns today on these real assets will
lead to a fall in the expected return on bonds relative to the expected return on real assets today and thus cause the
demand for bonds to fall. Alternatively, we can think of the rise in expected inflation as lowering the real interest
rate on bonds, and thus the resulting decline in the relative expected return on bonds will cause the demand for
bonds to fall.
- An increase in the expected rate of inflation lowers the expected return on bonds, causing their demand to
decline and the demand curve to shift to the left.

Risk
If prices in bond market become more volatile, risk associated with bonds increases; bonds become a less attractive
asset.
- An increase in riskiness of bonds causes demand for bonds to fall and demand curve to shift to the left.
If prices in another asset market (stock market) become more volatile, bonds become a more attractive asset.
- An increase in riskiness of alternative assets causes demand for bonds to rise and demand curve to shift to
right.

Liquidity
If more people started trading in the bond market, it became easier to sell bonds quickly; the increase in their
liquidity would cause the quantity of bonds demanded at each interest rate to rise.
- Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to
right.
- Similarly, increased liquidity of alternative assets lowers demand for bonds and shifts demand curve to left.
E.g., The reduction of brokerage commissions for trading common stocks that occurred when the fixed-rate commission
structure was abolished in 1975, increased the liquidity of stocks relative to bonds, and the resulting lower demand for bonds
shifted the demand curve to left.

Expected Profitability of Investment Opportunities

When opportunities for profitable plant and equipment investments are plentiful, firms are more willing to borrow to finance
these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are
expected to be profitable abound, and quantity of bonds supplied at any given bond price increases.
- In a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right.
- In in a recession, when far fewer profitable investment opportunities are expected, the supply of bonds falls and the
supply curve shifts to the left.

Expected Inflation
The real cost of borrowing is most accurately measured by the real interest rate, which equals the (nominal) interest rate minus
the expected inflation rate. For a given interest rate (and bond price), when expected inflation increases, the real cost of
borrowing falls; hence, the quantity of bonds supplied increases at any given bond price.
- An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right
- A decrease in expected inflation causes the supply of bonds to decrease and the supply curve to shift to the left.

Government Budget Deficits

Government Activities can influence supply of bonds in several ways. The Canadian government issues bonds to finance
government deficits, caused by gaps between government’s expenditures and its revenues. When these deficits are large, the
government sells more bonds, and the quantity of bonds supplied at each bond price increases.
- Higher government deficits increase the supply of bonds and shift the supply curve to the right.
- Government surpluses decrease the supply of bonds and shift the supply curve to the left.
Provincial and municipal governments and other government agencies also issue bonds to finance their expenditures, and this
can affect the supply of bonds as well.

The best way to analyze how the equilibrium interest rate can change by the shifting of supply and demand curves to is
to pursue several applications relevant to our understanding of how monetary policy affects interest rates.
In studying these applications:
1. When we examine the effect of a variable change, we assume that all other variables are unchanged; ceteris
paribus.
2. The interest rate is negatively related to the bond price, so when the equilibrium bond price rises, the equilibrium
interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.
Suppose that expected inflation is initially 5% and the initial supply and demand curves
Bs1 and Bd1 intersect at point 1, where the equilibrium bond price is P1. If expected
inflation rises to 10%, the expected return on bonds relative to real assets falls for any
given bond price and interest rate. As a result, the demand for bonds falls, and the
demand curve shifts to the left from Bd1 to Bd2. The rise in expected inflation also shifts
the supply curve. At any given bond price and interest rate, the real cost of borrowing
declines, causing the quantity of bonds supplied to increase and the supply curve to shift
to the right, from Bs1 to Bs2.
When the demand and supply curves shift in response to the change in expected inflation,
the equilibrium moves from point 1 to point 2, at the intersection of Bd2 and Bs2. The
equilibrium bond price falls from P1 to P2 and, because the bond price is negatively
related to the interest rate, this means that the interest rate rises. Note that Figure 5-4 has
been drawn so that the equilibrium quantity of bonds remains the same at both point 1
and point 2. However, depending on the size of the shifts in the supply and demand
curves, the equilibrium quantity of bonds can either rise or fall when expected inflation
rises.
Our supply and demand analysis has led us to an important observation: When expected
inflation rises, interest rates will rise. This result has been named the Fisher effect, after
Irving Fisher, the economist who first pointed out the relationship of expected inflation to
interest rates. The accuracy of this prediction is shown in Figure 5-5. The interest rate on
three-month Treasury bills has usually moved along with the expected inflation rate.
Consequently, many economists recommend that inflation must be kept low if we want to
keep nominal interest rates low.
Figure 5-6 analyzes the effects of a business cycle expansion on interest rates. In a business cycle
expansion, the amounts of goods and services being produced in the economy increase, so national
income rises. When this occurs, businesses are more willing to borrow because they are likely to have
many profitable investment opportunities for which they will need financing. Hence, at a given bond
price, the quantity of bonds that firms want to sell (that is, the supply of bonds) will increase. This
means that during a business cycle expansion, the supply curve for bonds shifts to the right (see Figure
5-6) from Bs1 to Bs2.

Expansion in the economy also affects the demand for bonds. As the economy expands, wealth is
likely to increase, and the theory of portfolio choice tells us that the demand for bonds will rise as
well. We see this in Figure 5-6, where the demand curve has shifted to the right, from Bd1 to Bd2.

Given that both the supply and demand curves have shifted to the right, we know that the new
equilibrium reached at the intersection of Bd2 and Bs2 must also move to the right. However,
depending on whether the supply curve shifts more than the demand curve or vice versa, the new
equilibrium interest rate can either rise or fall.
The supply and demand analysis used here gives us an ambiguous answer to the question of what
happens to interest rates in a business cycle expansion. Figure 5-6 has been drawn so that the shift in
the supply curve is greater than the shift in the demand curve, causing the equilibrium bond price to
fall to P2 and the equilibrium interest rate to rise. The reason the figure has been drawn such that a
business cycle expansion and a rise in income lead to a higher interest rate is that this is the outcome
we actually see in the data. Figure 5-7 plots the movement of the interest rate on three- month
Treasury bills from 1962 to 2014 and indicates when the business cycle went through recessions
(shaded areas). As you can see, the interest rate tends to rise during business cycle expansions and fall
during recessions, as indicated by the supply and demand diagram in Figure 5-6.