Chapter 5. The Behavior of Interest Rates

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Chapter 5. The Behavior of Interest Rates

• asset demand
• bond market
• money demand and supply

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I. Asset demand

• which asset to choose?
• depends on RELATIVE comparisons between choices

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A. Wealth

• greater wealth, greater resources

wealth
Qd of assets

• holding other factors constant

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B. Expected returns

• based on expected cash flows,
• price changes

Exp ret. of asset
Qd of that asset

• holding other factors constant

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C. Risk

• variation in assets return
• people are risk averse
• prefer lower risk if other factors the same

risk of asset
Qd of that asset

• holding other factors constant

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D. Liquidity

• how easy is asset to convert to cash?
• Tbill easy
• real estate hard

liquidity of asset
Qd of that asset

• holding other factors constant

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II. The Bond Market

• A. Bond Demand
• bond buyers/ lenders/ savers
• look at Qd as a function of expected return, price

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example

• 1 year, zero coupon bond
• YTM exp. return

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Bond Price i exp. return 700 42.86 750 3
3.33 800 25 850 17.65 900 11.11 950
5.26
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Exp ret. of bond
Qd of bonds
price of bond
Qd of bonds

• so bond demand slopes down with respect to price

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Bond demand
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shifts in bond demand

• a change in wealth

demand for bonds (shift rt.)
wealth
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• a change in exp. interest rates
• rising interest rates decrease value of existing
  bonds

int. rates expected to
demand for bonds (shift left)
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• a change in expected inflation
• rising inflation decreases real return

inflation expected to
demand for bonds (shift left)
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• a change in the risk of bonds relative to other
  assets

relative risk of bonds
demand for bonds (shift left)
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• a change in liquidity of bonds relative to other
  assets

relative liquidity of bonds
demand for bonds (shift rt.)
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B. Bond supply

• bond issuers/ borrowers
• look at Qs as a function of price, yield

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• lower bond prices
• higher bond yields
• more expensive to borrow
• lower Qs of bonds
• so bond supply slopes up with price

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bond supply
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shifts in bond supply

• a change in expected profits
• affects incentives to expand production

supply of bonds (shift rt.)
exp. profits

• exp. economic expansion shifts bond supply rt.

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• a change in expected inflation
• rising inflation decreases real cost of borrowing

supply of bonds (shift rt.)
exp. inflation
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• a change in government borrowing
• deficits increase Treasury issues
• surpluses decrease Treasury issues

supply of bonds (shift rt.)
deficits
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• demand for bonds
• supply of loanable funds
• supply of bonds
• demand for loanable funds

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C. Equilibrium interest rates

• changes when bond demand shifts,
• and/or bond supply shifts
• causes of shifts cause interest rates to change

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Example 1 the Fisher effect

• expected inflation 3

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• exp. inflation rises to 4
• bond demand
• -- real return declines
• -- Bd decreases
• bond supply
• -- real cost of borrowing declines
• -- Bs increases

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• bond price falls
• interest rate rises

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Fisher effect

• expected inflation rises,
• nominal interest rates rise

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Example 2 economic slowdown
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• bond demand
• decline in income, wealth
• Bd decreases
• P falls, i rises
• bond supply
• decline in exp. profits
• Bs decreases
• P rises, i falls

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• shift Bs gt shift in Bd
• interest rate falls

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Why shift Bs gt shift Bd?

• changes in wealth are small
• response to change in exp. profits is large
• large cyclical swings in investment

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example 6

• how does bond market explain
• behavior of 30 yr. Treasury yield?
• 2000-2001
• 30 yr. yield lt 10 yr. yield
• Usually,
• -- 30 yr gt 10 yr

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Why the switch?

• Bond supply
• Treasury cut back on 30 yr issues
• -- due to budget surplus
• Bs decreases for 30 yr. Tbonds
• -- price rises, yield falls
• Bs of 10 yr. Tnotes not affected

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II. Liquidity Preference

• money demand money supply

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A. Money demand

• consider M1
• assets earn little or no interest
• holding money vs. bonds
• bonds earn interest
• money is more liquid
• -- holding money shows preference for liquidity

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• interest rate is opportunity cost of holding
  money
• higher interest rate, hold less money
• money demand slopes down with respect to interest
  rate

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money demand
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what shifts Md?

• a change in income
• income increase,
• buy more stuff
• save more money
• -- Md increases (shift rt.)

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• a change in price level
• prices increase,
• need more money
• to buy same amount of stuff
• -- Md increases

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• a change in technology
• ATM/ debit cards
• -- hold less cash
• -- easier access to savings
• -- hold less M1
• -- Md decreases

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B. Money supply

• controlled by central bank
• Federal Reserve System
• assume complete control
• Ms is vertical

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Md and Ms
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what shifts Ms?

• a change in Federal Reserve policy
• Fed increases Ms
• Fed decreases Ms
• Fed has several tools to do this
• -- chapter 17

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C. Money Interest Rates

• shifts in Md and/or Ms
• changes in interest rate

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example 3

• economic expansion increases income

• interest rate rises

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example 4

• economic expansion increases prices

• interest rate rises

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example 5

• Federal Reserve increases Ms

• interest rate falls

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Does an increase in Ms lower i ?

• example 5
• MS shifts right
• i falls
• this is called the liquidity effect,
• but it doesnt stop there.

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• but lower i will lead to economic expansion
• consumers borrow and buy
• firms borrow and invest
• income rises
• -- MD shifts right
• -- i rises

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income effect
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• economic expansion can lead to
• higher prices
• increase MD and i

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price level effect
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expected inflation effect

• if people expect increase in Ms,
• expect increase in P
• expect inflation
• Fisher effect
• increase in exp. inflation
• increase in i

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total effect of increase in Ms?

• depends on which effect is larger
• if liquidity effect is greater
• then i will fall
• if other effects are greater
• then i will rise

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evidence?

• little evidence that liquidity effect dominates
• perhaps in short-run
• increase in MS does not impact long-term rates as
  much as exp. inflation

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In summary,

• interest rates determined by supply and demand
• bond market
• money market
• shifts in demand/supply curves
• changes in general level of interest rates