The determination of bond prices and interest rates

1
The determination of bond prices and interest
rates

• Mishkin, Chap 5

2

• Chap 5 discusses
• The classical theory of bond prices and interest
  rates
• The liquidity preference theory (Keynesian
  theory) of bond prices and interest rates
• Critique of the liquidity preference theory -
  Money supply and the market interest rates

3

• Difference between a market for loans and a bond
  market
• In a market for loans, the interest rate on a
  loan is determined by market forces of demand and
  supply. Given a LV and n, the FP is then
  determined from the PV relationship.
  Equivalently, given FP and n, the LV is then
  determined from the PV relationship.
• In a market for bonds, the bond price is
  determined by market forces or demand and supply.
  Given C, FV and n, the interest rate or yield to
  maturity is then determined from the PV
  relationship.
• Thus the difference lies in which is regarded as
  the market determined variable price or
  interest rate.

4

• The classical theory of bond prices and interest
  rates
• Demand for a bond (generally for any asset)
  depends on
• average time preference of households the more
  willing the households are to defer their current
  consumption the _______ is the demand for bonds
• average wealth level of households effect is
  ________
• expected return on the bond over the holding
  period effect is __________
• the risk on the bond assuming agents to be risk
  averse, the effect should be _______. Risk may be
  measured by _______
• the liquidity of the bond effect is _____.
  Liquidity can be measured by ________

5
Given wealth, savings propensities, risk and
liquidity, quantity demanded of bond is
positively related to the expected return on
it. If so, how is the quantity demanded related
to the current market price of the bond? Hint
for short term investors, RET (C Pt1
Pt)/Pt for someone who keeps it till
maturity RET yield to maturity on a bond based
on the current market price How is RET related to
Pt in both cases? Hence quantity demanded is
_______ related to current market price.
Equivalently quantity demanded is _______ related
to its current YTM. The book shows this for the
special case of a one period discount bond but
this is true for all bonds.
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Supply of bonds is _______related to its current
market price everything else constant
Why? Hint From the issuers (borrowers) point
of view, what is the cost of borrowing? Equilibriu
m in the bond market the price at which quantity
demanded equals quantity supplied. If bond price
is at any other level, adjustments similar to
other competitive markets take place. Equilibrium
price implies a corresponding equilibrium
interest rate.
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price of the bond

• Draw the demand and supply of the bond. Indicate
  the sources of each (who demands or supplies?)
• Add a third interest rate axis to alternatively
  express these relationships.

quantity of the bond
8
The market for loanable funds is another name for
the market for bonds. Demand for bonds
__________ loanable fundsSupply of bonds
__________ loanable funds
Interest rate
Draw the supply of and demand for loanable funds
and also mark them with their alternative labels.
Quantity of bonds
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• Factors affecting demand, supply and the
  equilibrium interest rate
• increase in the average wealth level?
• 2. increase in expected (future) interest rate?

Price of the bond
S0
D0
Quantity of the bond
Price of the bond
Hint What happens to the future price of the
bond? What happens to the one period rate of
return?
S0
D0
Quantity of the bond
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3. increase in the expected return on an
alternative asset such as a stock or another
bond? 4. increase in the riskiness of the
bond
Price of the bond
S0
D0
Quantity of the bond
How would an increase in risk on an alternative
asset affect the demand of this bond?
P
S0
D0
Q
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5. increase in the liquidity of the bond?
6. Increase in the expected (future)
inflation rate?
P
How would an increase in risk on an alternative
asset affect the demand of this bond?
S0
D0
Q
P
Hint Assume this is a nominal bond. What happens
to the equilibrium nominal interest rate?
S0
D0
Q
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• increase in business profitability?
• 8. increase in the government budget deficit?

P
S0
D0
Q
P
S0
D0
Q
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Changes in ?e the Fisher Effect
Price of a bond
What happens to demand and supply as pe
increases? Are the shifts equal? What happens to
equilibrium price? Equilibrium quantity? Equilibri
um nominal interest rate?
S0
D0
Quantity of bond
14
Effects of Business cycles - expansion
Price of a bond
What happens to demand and supply during
expansions? Are the shifts equal? What happens to
equilibrium price? Equilibrium quantity? Equilibri
um interest rate?
S0
D0
Quantity of bond
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II. Liquidity preference or Keynesian theory of
the interest rate Assumption only 2 types of
assets, bonds and money Bs Ms Bd Md total
wealth of individuals or Bs Bd Md Ms If
the money market is in equilibrium, the bond
market is in equilibrium also. Excess supply in
the bond market implies excess demand in the
money market and the reverse. Thus one can study
the bond market by studying the money market.
(Note method doesnt work if there are more than
2 assets) Demand for money money is demanded i)
because of its liquidity ii) as a store of value.
The second component is negatively related to
the interest rate the first component is
independent of the interest rate, positively
related to income and the price level.
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Supply of money assumed to be constant for the
present assumption can be relaxed doesnt
affect conclusions of the model. We assume Ms is
measured as M1. Money market equilibrium Md Ms
Interest rate
Draw the demand for and supply of money and show
the equilibrium interest rate.
Quantity of money
17
Factors that affect demand, supply and the
equilibrium interest rate, according to the
liquidity preference theory 1. an increase in
income? 2. an increase in the price level?
3. An increase in money supply?
Interest rate
i
Quantity of money
M
i
(3) is called the liquidity effect of an increase
in money supply.
M
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III. Critique of LP theory The Keynesian theory
ignores some other effects of an increase in
money supply on the interest rate. These are
- - - Of the above three, the classical theory
of interest emphasizes _____ as the most
important quantitatively in the long run.