chapter 5 The Behavior of Interest Rates Determinants

chapter 5 The Behavior of Interest Rates

Determinants of Asset Demand Copyright © 2001 Addison Wesley Longman TM 5 - 2

Derivation of Bond Demand Curve e i = RET = (F – P) P

Derivation of Bond Demand Curve Point B: P = $900 i= ($1000 – $900) = 0. 111 = 11. 1% $900 d B = $200 billion d Point C: P = $850 i = 17. 6% B = $300 billion d Point D: P = $800 i = 25. 0% B = $400 billion d Point E: P = $750 i = 33. 0% B = $500 billion d Demand Curve is B in Figure 1 which connects points A, B, C, D, E. Has usual downward slope Copyright © 2001 Addison Wesley Longman TM 5 - 4

Derivation of Bond Supply Curve s Point F: P = $750 i = 33. 0% B = $100 billion Point G: s P = $800 i = 25. 0% B = $200 billion s Point C: P = $850 i = 17. 6% B = $300 billion Point H: s P = $900 i = 11. 1% B = $400 billion s Point I: P = $950 i = 5. 3% B = $500 billion s Supply Curve is B that connects points F, G, C, H, I, and has upward slope Copyright © 2001 Addison Wesley Longman TM 5 - 5

Supply and Demand Analysis of the Bond Market Equilibrium d s 1. Occurs when B = B , at P* = $850, i* = 17. 6% s 2. When P = $950, i = 5. 3%, B > d B (excess supply): P to P*, i to i* d 3. When P = $750, i = 33. 0, B > s B (excess demand): P to P*, i to i* Copyright © 2001 Addison Wesley Longman TM 5 - 6

Shifts in the Bond Demand Curve Copyright © 2001 Addison Wesley Longman TM 5

Factors that Shift the Bond Demand Curve: 1. Wealth A. Economy , wealth , Bd shifts out to right 2. Expected Return A. i in future, RETe for long-term bonds , Bd shifts out to right B. e , Relative RETe , Bd shifts out to right 3. Risk A. Risk of bonds , Bd shifts out to right B. Risk of other assets , Bd shifts out to right 4. Liquidity A. Liquidity of Bonds , Bd shifts out to right B. Liquidity of other assets , Bd shifts out to right Copyright © 2001 Addison Wesley Longman TM 5 - 8

Factors that Shift Demand Curve for Bonds Copyright © 2001 Addison Wesley Longman TM

Shifts in the Bond Supply Curve 1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , Bs shifts out to right 2. Expected Inflation e , Bs shifts out to right 3. Government Activities Deficits , Bs shifts out to right Copyright © 2001 Addison Wesley Longman TM 5 - 10

Factors that Shift Supply Curve for Bonds Copyright © 2001 Addison Wesley Longman TM

Changes in e: the Fisher Effect If e 1. Relative RETe , Bd shifts

Evidence on the Fisher Effect in the United States Copyright © 2001 Addison Wesley

Business Cycle Expansion 1. Wealth , Bd shifts out to right 2. Investment ,

Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two Categories of Assets in Wealth Money Bonds 1. Thus: Ms + Bs = Wealth 2. Budget Constraint: 3. Therefore: Bd + Md = Wealth Ms + B s = B d + Md 4. Subtracting Md and Bs from both sides: Ms – Md = B d – B s Money Market Equilibrium 5. Occurs when Md = Ms 6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd = Bs and bond market is also in equilibrium Copyright © 2001 Addison Wesley Longman TM 5 - 15

1. Equating supply and demand for bonds as in loanable funds framework is equivalent to equating supply and demand for money as in liquidity preference framework 2. Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects from changes in expected returns on real assets Copyright © 2001 Addison Wesley Longman TM 5 - 16

Liquidity Preference Analysis Derivation of Demand Curve 1. Keynes assumed money has i = 0 e 2. As i , relative RET on money (equivalently, opportunity cost of d money ) M 3. Demand curve for money has usual downward slope Derivation of Supply curve s 1. Assume that central bank controls M and it is a fixed amount s 2. M curve is vertical line Market Equilibrium d s 1. Occurs when M = M , at i* = 15% s d 2. If i = 25%, M > M (excess supply): Price of bonds , i to i* = 15% d s 3. If i =5%, M > M (excess demand): Price of bonds , i to i* = 15% Copyright © 2001 Addison Wesley Longman TM 5 - 17

Money Market Equilibrium Copyright © 2001 Addison Wesley Longman TM 5 - 18

Rise in Income or the Price Level 1. Income , Md shifts out to

Rise in Money Supply 1. Ms , Ms shifts out to right 2. Md

Factors that Shift Money Demand Supply Curves Copyright © 2001 Addison Wesley Longman TM

Money and Interest Rates Effects of money on interest rates 1. Liquidity Effect Ms , Ms shifts right, i 2. Income Effect Ms , Income , Md shifts right, i 3. Price Level Effect Ms , Price level , Md shifts right, i 4. Expected Inflation Effect Ms , e , Bd , Bs , Fisher effect, i Effect of higher rate of money growth on interest rates is ambiguous 1. work Because income, price level and expected inflation effects in opposite direction of liquidity effect Copyright © 2001 Addison Wesley Longman TM 5 - 22