ABSTRACT
This chapter presents the expectations affect prices of financial instruments. It relates expected rates of return to the prices of long-term financial instruments. To streamline the analysis, we focus on how stock and bond prices are related while recognizing that the analysis could be extended to other long-term financial instruments such as mortgages. In managing a portfolio, market participants compare expected rates of return for various financial instruments and select a combination of those with the highest expected return consistent with varying degrees of risk and liquidity. Economists have spent a great deal of time and energy in developing various theories of how expectations are formed by market participants. The chapter discusses the financial flows of funds among sectors and their relationship to the economy. It constructs a hypothetical sources and uses of funds table for the US economy. For the economy as a whole, combined surpluses of the surplus sectors must equal the combined deficits of the deficit sectors.
