Presentation is loading. Please wait.

Presentation is loading. Please wait.

5.5-1 Lecture 12 The Behavior of Interest Rates. 5.5-2 Derivation of Demand Curve (F – P) i = RET e = ——— P Point A: P = $950 ($1000 – $950) i =——————

Similar presentations


Presentation on theme: "5.5-1 Lecture 12 The Behavior of Interest Rates. 5.5-2 Derivation of Demand Curve (F – P) i = RET e = ——— P Point A: P = $950 ($1000 – $950) i =——————"— Presentation transcript:

1 5.5-1 Lecture 12 The Behavior of Interest Rates

2 5.5-2 Derivation of Demand Curve (F – P) i = RET e = ——— P Point A: P = $950 ($1000 – $950) i =—————— =.053 = 5.3% $950 B d = 100

3 5.5-3 Derivation of Demand Curve Point B: P = $900 ($1000 – $900) i =——————=.011 = 11.1% $900 B d = 200 Point C: P = $850 i = 17.6% B d = 300 Point D: P = $800 i = 25.0% B d = 400 Point E: P = $750 i = 33.0% B d = 500 Demand Curve is B d in Figure 1 which connects points A, B, C, D, E. Has usual downward slope

4 5.5-4 Supply and Demand Analysis of the Bond Market

5 5.5-5 Derivation of Supply Curve Point F:P = $750 i = 33.0% B s = 100 Point G:P = $800 i = 25.0% B s = 200 Point C:P = $850 i = 17.6% B s = 300 Point H:P = $900 i = 11.1% B s = 400 Point I:P = $950 i = 5.3% B s = 500 Supply Curve is B s that connects points F, G, C, H, I, and has upward slope Market Equilibrium 1. Occurs when B d = B s, at P* = 850, i* = 17.6% 2. When P = $950, i = 5.3%, B s > B d (excess supply): P  to P*, i  to i* 3. When P = $750, i = 33.0, B d > B s (excess demand): P  to P*, i  to i*

6 5.5-6 Loanable Funds Terminology 1.Demand for bonds = supply of loanable funds 2.Supply of bonds = demand for loanable funds

7 5.5-7 Shifts in the Demand Curve

8 5.5-8 Theory of Asset Demand 1. Wealth A.Economy , wealth , B d , B d shifts out to right 2. Expected Return A.i  in future, RET e for long-term bonds , B d shifts out to right B.  e , Relative RET e , B d shifts out to right 3. Risk A.Risk of bonds , B d , B d shifts out to right B.Risk of other assets , B d , B d shifts out to right 4. Liquidity A.Liquidity of Bonds , B d , B d shifts out to right B.Liquidity of other assets , B d ,B d shifts out to right

9 5.5-9 Factors that Shift Demand Curve

10 Shifts in the Supply Curve 1.Profitability of Investment Opportunities A.Business cycle expansion, investment opportunities , Bs , B s shifts out to right 2.Expected Inflation A.  e , B s , B s shifts out to right 3.Government Activities A.Deficits , B s , B s shifts out to right

11 Factors that Shift Supply Curve

12 Changes in  e : the Fisher Effect If  e  1.Relative RET e , B d shifts in to left 2.B s , B s shifts out to right 3.P , i 

13 Evidence on the Fisher Effect in the United States

14 Business Cycle Expansion 1.Wealth , B d , B d shifts out to right 2.Investment , B s , B s shifts right 3.If B s shifts more than B d then P , i 

15 Evidence on Business Cycles and Interest Rates

16 Response to a Low Savings Rate

17 Relation of Liquidity Preference Framework to Loanable Funds Keynes Major Assumption Two categories of assets in wealth 1. money 2. bonds 1.Thus:M s + B s = Wealth 2.Budget Constraint:B d + M d = Wealth 3.Therefore:M s + B s = B d + M d 4.Subtracting M d and B s from both sides: M s – M d = B d – B s Money Market Equilibrium 5.Occurs when M d = M s 6.Then M d – M s = 0 which implies that B d – B s = 0, so that B d = B s and bond market is also in equilibrium

18 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

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

20 Money Market Equilibrium

21 Rise in Income 1.Income , M d , M d shifts out to right 2.M s unchanged 3i* rises from i 1 to i 2

22 Rise in Price Level 1.Price level , M d , M d shifts to right 2.M s unchanged 3.i* rises from i 1 to i 2

23 Rise in Money Supply 1.M s , M s shifts out to right 2.M d unchanged 3.i* falls from i 1 to i 2

24 Factors that Shift Money Demand and Supply Curves

25 Money and Interest Rates Effects of money on interest rates 1. Liquidity Effect M s , M s shifts right, i  2. Income Effect M s , Income , M d , M d shifts right, i  3. Price Level Effect M s , Price level , M d , M d shifts right, i  4. Expected Inflation Effect M s ,  e , B d , B s , Fisher effect, i  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

26 Does Higher Money Growth Lower Interest Rates?

27 Evidence on Money Growth and Interest Rates

28 Supply and Demand in Gold Market Deriving Demand Curve P +1 – P t RET e =—————= g P t 1.P +1 is held constant 2.P t , g , RET e  fi G d  3.Demand curve is downward sloping Deriving Supply Curve 1.P t , more production, G s  2.Supply curve is upward sloping Market Equilibrium 1.G d = G s 2.If P t > P* = P 1, G s > G d, P t  to P* 3..If P t < P* = P 1, G s < G d, P t  to P*

29 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

30 [Figure A-1 here] Response of Gold Market to a Change in  e If  e  1.  e , P +1  ; at given P t, g  fi G d  fi G d shifts right 2.Go to point 2; P t  3.Price of Gold positively related to  e 4.Gold price is barometer of  -pressure


Download ppt "5.5-1 Lecture 12 The Behavior of Interest Rates. 5.5-2 Derivation of Demand Curve (F – P) i = RET e = ——— P Point A: P = $950 ($1000 – $950) i =——————"

Similar presentations


Ads by Google