Lecture

The Behavior of Interest Rates

Chapter 5
 Motivation
Monetary Policy works primarily by
manipulating interest rates

Interest rates are determined in the bond

market by the demand and supply for bonds

Interest rates change because of shifts in

demand and supply for bonds
Interest Rates on Selected Bonds, 19502015
Three things this graph demonstrates??
3-month Bill
10-year Treasury
10-year Corporate Baa
We look at three perspectives on the bond market

Bonds as financial assets: Theory of asset demand and

asset allocation. S&D for Bonds.

Loanable funds: Supply & Demand for loanable funds.

Savings and Investment. Bond demand is one component of
the aggregate supply of loanable funds.

Whats being traded - Bonds or the use of funds?

Liquidity Preference: View bonds as an alternative to

holding money.
 Bonds as a Financial Asset
Demand for Financial Assets
Wealth - the total resources owned by the individual,
including all assets
Expected Return - the return expected over the next period
on one asset relative to alternative assets
Risk - the degree of uncertainty associated with the return
on one asset relative to alternative assets
Liquidity - the ease and speed with which an asset can be
turned into cash relative to alternative assets
 Demand for Financial Assets
Holding all other factors constant, the demand
for an asset is:
positively related to wealth
positively related to its expected return
relative to alternative assets
negatively related to the risk of its returns
relative to alternative assets
positively related to its liquidity relative to
alternative assets
Demand and Supply Curves for Bonds
At lower prices (higher interest rates),
ceteris paribus, the quantity demanded of
bonds (lenders) is higher - an inverse
relationship
At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds (borrowers) is lower - a positive
relationship
This example is for a one-year zero coupon bond
Market Equilibrium
Occurs when the quantity that people are willing to
buy equals the quantity that people are willing to
sell at a given price.
Bd = Bs : the equilibrium or market clearing price
and interest rate.
When Bd > Bs : excess demand, investors will bid-
up the price and interest rate will fall.
When Bd < Bs : excess supply, sellers will lower the
price and interest rate will rise
 How Factors Shift the Demand Curve
1. Wealth/saving
As economy grows, income and wealth
increase
Bd => Bd shifts out to right

As economy contracts, income and

wealth fall
Bd , => Bd shifts in to left
 How Factors Shift the Demand Curve
2. Expected Returns on bonds
If i is expected to fall in future,
expected return for long-term bonds
Bd shifts out to right (increase in demand)

If i is expected to rise in future, expected

return for long-term bonds
Bd shifts in to left (decrease in demand)
 How Factors Shift the Demand Curve
3. Expected Returns on other assets
As the expected return on other asset
increase relative to return for long-term
bonds
Bonds become less attractive

Bd shifts in to left (decrease in demand)

 How Factors Shift the Demand Curve
4. Risk -
Risk of bonds , Bd
Bd shifts out to right

Risk of other assets , Bd

Bd shifts out to right
How Factors Shift the Demand Curve
5. Liquidity
Liquidity of bonds , Bd
Bd shifts out to right

Liquidity of other assets , Bd

Bd shifts out to right
Shift in the Demand Curve for Bonds
 Shifts in the Supply of Bonds
1. Expected Profitability of Investment
Opportunities:
in a business cycle expansion, the supply of bonds
increases, conversely, in a recession, when there are far
fewer expected profitable investment opportunities, the
supply of bonds falls
2. Expected Inflation:
an increase in expected inflation causes the supply of bonds
to increase
3. Government Activities:
higher government deficits increase the supply of bonds,
conversely, government surpluses decrease the supply of
bonds
Shift in the Supply Curve for Bonds
Case Study - Response to an Expected
Increase in the Rate of Inflation
Expected Inflation and Interest Rates (Three-
Month Treasury Bills), 19532011
FIGURE 7 Business Cycle and Interest Rates (Three-Month Treasury
Bills), 19512008
Response to a Business Cycle Expansion
What Happened in May 2013?

5-22
What
happened
here?
Loanable Funds - Use of Funds Approach

1. Demand for
bonds = supply
of loanable
funds
2. Supply of bonds
= demand for
loanable funds
 Liquidity Preference Framework
proposed by John Maynard
Keynes.
from the perspective of
money
assume there are 2 assets:
bond + money = total wealth

25
 The Liquidity Preference Framework
two assets: bonds + money = total wealth
supply side: Ms + Bs = Wealth
demand side: Bd + Md = Wealth
Ms + Bs = Bd + Md
Re-arranging:
Ms Md = Bd Bs
Md - Ms
Conclusion:
If money market is in equilibrium (money
demand equals money supply: Md = Ms ), then
bond market is also in equilibrium (bond
demand equals bond supply: Bd = Bs).
 Keynesian Liquidity Preference Analysis
Derivation of Demand Curve
As i , the opportunity cost of holding money
Md The demand curve for money has the usual
downward slope

Derivation of Supply curve

Assume that central bank controls Ms and it is a
fixed amount. Ms curve is vertical line

Market Equilibrium
Occurs when Md = Ms
Equilibrium in the Market for Money
 Market equilibrium
equilibrium quantity of money: Md = Ms
equilibrium interest rate: i*

If i > i* , Ms > Md (excess supply of money)

Central bank supply of money is greater than the
amount of money people are willing to hold
price of bonds , i back to i*

If i < i*, Md > Ms (excess demand for money)

price of bonds , i back to i*

29
Shifts in the Demand for Money
Income Effect - a higher level of income
causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
Price-Level Effect - a rise in the price level
causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
Increase in Income or the Price Level
Shifts in the Supply of Money
The supply of money is controlled by the
central bank

An increase in the money supply by the

Federal Reserve will shift the supply
curve for money to the right
Response to an Increase in Money Supply
Does Everything Else Remain Equal?
Liquidity preference framework says that an
increase in the money supply will lower
interest rates, if other things remain
unchanged - the liquidity effect.
Noble prize winner Milton Friedman argued:
Over time, as the economy expands and
income increases, get an Income Effect.
The demand curve for money, Md , shifts to
the right and interest rates begin to rise.
 Everything Else Remaining Equal (?)
Also, over time, can get a Price Level
effect. A rise in the price level causes
demand curve for money to shift to the right
which will cause interest rates to rise.
There may also be an Expected-Inflation
effect which causes an increase in interest
rates because the increase in the money
supply may lead people to expect a higher
price level in the future (the demand curve
shifts to the right).
Read Mishkin Carefully - Note the shift from money supply to
growth in the money supply.
Price-Level Effect and Expected-Inflation Effect
A one time increase in the money supply will
cause prices to rise to a permanently higher level
by the end of the year. The interest rate will rise
via the increased prices.
A rising price level will raise interest rates because
people will expect inflation to be higher over the
course of the year. When the price level stops
rising, expectations of inflation will return to zero.
Read Mishkin Carefully - Note the shift from money
supply to growth in the money supply
Price-Level Effect and Expected-Inflation Effect

Expected-inflation effect persists only as

long as the price level continues to rise
which requires continued money growth.
Money Supply Growth and the Effects on
Interest Rates

Liquidity Effect: Ms growth i

Income Effect: i Income Md i

Price Level Effect: Income Price level Md i

Expected Inflation Effect: Ms Price level e Bd

Bs Fisher effect i

Whats the net effect on interest rate?

Effect of higher rate of money growth on
interest rates is ambiguous.
When
Does
Higher
Money
Growth
Lower
Interest
Rates?