Chapter Four BEHAVIOR OF INTEREST RATES Copyright 2000

Determinants of Asset Demand Copyright © 2000 Addison Wesley Longman Slide #4 -2

Benefits of Diversification 1. Diversification almost always beneficial to risk-averse investor 2. Less returns of securities move together, greater is risk reduction from diversification Copyright © 2000 Addison Wesley Longman Slide #4 -3

Derivation of Demand Curve i = RETe = (F - P) P Point A: P = $950 i = ($1000 - $950) =. 053 = 5. 3% $950 Bd = 100 Point B: P = $900 i = ($1000 - $900) =. 111 = 11. 1% $900 Bd = 200 Copyright © 2000 Addison Wesley Longman Slide #4 -4

Derivation of Demand Curve Point C: P = $850 i = 17. 6% Bd = 300 Point D: P = $800 i = 25. 0% Bd = 400 Point E: P = $750 i = 33. 0% Bd = 500 Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E. Has usual downward slope Copyright © 2000 Addison Wesley Longman Slide #4 -5

Supply and Demand Analysis of the Bond Market Copyright © 2000 Addison Wesley Longman

Derivation of Supply Curve Point F: Point G: Point C: Point H: Point I: P = $750 P = $800 P = $850 P = $900 P = $950 i = 33. 0% i = 25. 0% i = 17. 6% i = 11. 1% i = 5. 3% Bs = 100 Bs = 200 Bs = 300 Bs = 400 Bs = 500 Supply Curve is Bs that connects points F, G, C, H, I, and has upward slope Copyright © 2000 Addison Wesley Longman Slide #4 -7

Market Equilibrium 1. Occurs when Bd = Bs, at P* = 850, i* = 17. 6% 2. When P = $950, i = 5. 3%, Bs > Bd (excess supply): P to P*, i to i* 3. When P = $750, i = 33. 0, Bd > Bs (excess demand): P to P*, i to i* Copyright © 2000 Addison Wesley Longman Slide #4 -8

Loanable Funds Terminology 1. Demand for bonds = supply of loanable funds 2. Supply

Shifts in the Demand Curve Copyright © 2000 Addison Wesley Longman Slide #4 -10

How Factors Shift the 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. πe , 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 © 2000 Addison Wesley Longman Slide #4 -11

Factors that Shift Demand Curve Copyright © 2000 Addison Wesley Longman Slide #4 -12

Shifts in the Supply Curve 1. Profitability of Investment Opportunities • Business cycle expansion, investment opportunities , Bs shifts out to right 2. Expected Inflation • πe , Bs shifts out to right 3. Government Activities • Deficits , Bs shifts out to right Copyright © 2000 Addison Wesley Longman Slide #4 -13

Factors that Shift Supply Curve Copyright © 2000 Addison Wesley Longman Slide #4 -14

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

Evidence on the Fisher Effect in the United States Copyright © 2000 Addison Wesley

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

Evidence on Business Cycles and Interest Rates Copyright © 2000 Addison Wesley Longman Slide

Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two categories of assets in wealth 1. money 2. bonds 1. 2. 3. 4. Thus: Ms + Bs = Wealth Budget constraint: Bd + Md = Wealth Therefore: Ms + B s = B d + Md Subtracting Md and Bs from both sides: Ms - Md = B d - B s Copyright © 2000 Addison Wesley Longman Slide #4 -19

Relation of Liquidity Preference Framework to Loanable Funds 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 © 2000 Addison Wesley Longman Slide #4 -20

Relation of Liquidity Preference Framework to Loanable Funds 1. Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money 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 © 2000 Addison Wesley Longman Slide #4 -21

Liquidity Preference Analysis Derivation of Demand Curve 1. Keynes assumed money has i = 0 2. As i , relative RETe on money (equivalently, opportunity cost of money ) Md 3. Demand curve for money has usual downward slope Derivation of Supply curve 1. Assume that central bank controls Ms and is a fixed amount 2. Ms curve is vertical line Copyright © 2000 Addison Wesley Longman Slide #4 -22

Liquidity Preference Analysis Market Equilibrium 1. Occurs when Md = Ms, at i* = 15% 2. If i = 25%, Ms > Md (excess supply): Price of bonds , i to i* = 15% 3. If i =5%, Md > Ms (excess demand): Price of bonds , i to i* = 15% Copyright © 2000 Addison Wesley Longman Slide #4 -23

Money Market Equilibrium Copyright © 2000 Addison Wesley Longman Slide #4 -24

Rise in Income 1. Income , Md shifts out to right 2. Ms unchanged

Rise in Price Level 1. Price level , Md shifts to right 2. Ms

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

Factors that Shift Money Demand Supply Curves Copyright © 2000 Addison Wesley Longman Slide

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 , πe , Bd , Bs , Fisher effect, i Copyright © 2000 Addison Wesley Longman Slide #4 -29

Money and Interest Rates Effect of higher rate of money growth on interest rates is ambiguous 1. Because income, price level and expected inflation effects work in opposite direction of liquidity effect Copyright © 2000 Addison Wesley Longman Slide #4 -30

Does Higher Money Growth Lower Interest Rates? Copyright © 2000 Addison Wesley Longman Slide

Evidence on Money Growth and Interest Rates Copyright © 2000 Addison Wesley Longman Slide

Profiting from Interest-Rate Forecasts Methods for Forecasting 1. Loanable funds: use Flow of Funds Accounts and judgement 2. Econometric Models: large in scale, use liquidity preference Make decisions about assets to hold 1. Forecast i , buy long bonds 2. Forecast i , buy short bonds Make decisions about how to borrow 1. Forecast i , borrow short 2. Forecast i , borrow long Copyright © 2000 Addison Wesley Longman Slide #4 -33

Supply and Demand in Gold Market Deriving Demand Curve 1. Pet+1 is held constant 2. Pt , ge , RETe Gd 3. Demand curve is downward sloping Deriving Supply Curve 1. Pt , more production, Gs 2. Supply curve is upward sloping Copyright © 2000 Addison Wesley Longman Slide #4 -34

Supply and Demand in Gold Market Equilibrium 1. Gd = Gs 2. If Pt

Changes in Equilibrium Factors that Shift Demand Curve for Gold 1. Wealth 2. Expected return on gold relative to alternative assets 3. Riskiness of gold relative to alternative assets 4. Liquidity of gold relative to alternative assets Factors that Shift Supply Curve for Gold 1. Technology of mining 2. Government sales of gold Copyright © 2000 Addison Wesley Longman Slide #4 -36

Response of Gold Market to a If πe Change in πe 1. πe , Pet+1 ; at given Pt, ge G d Gd shifts right 2. Go to point 2; Pt 3. Price of gold positively related to πe 4. Gold price is barometer of π-pressure Copyright © 2000 Addison Wesley Longman Slide #4 -37