1. FNCE 3020 Financial Markets and Institutions Fall Semester 2005 Lecture 3 The Behavior of Interest Rates

2. How Might We Examine How Interest Rates Behave? Through the Loanable Funds Model  Begin with Bond Market Model: i.e., demand and supply analysis of bonds in the bond market! What happens to the quantity demand and quantity supplied of bonds as we varying the price!  Then: Move from Bond Market Model to Loanable Funds Model, where: The Demand for bonds = supply of loanable funds The Supply of bonds = demand for loanable funds

3. Determinants of Financial Asset Demand Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1. Wealth, the total resources owned by the individual, including all assets held. 2. Expected return (the return expected over the next period) on one asset relative to alternative assets. 3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets. 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets.

4. Changes in the Quantity Demanded The quantity demanded of an asset differs according to: 1. Wealth: Holding everything else constant, an increase in wealth raises the quantity demanded of an asset. 2. Expected return: An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset. 3. Risk: Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. 4. Liquidity: The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded.

5. Summary Table: Response of Demand to Changes in Four Factors

6. Derivation of Demand Curve for Bonds Demand Curve: Shows the relationship between the quantity demanded (for bonds) and the price of a bond, when all other factors are held constant. Demand for a 1 year discount bond can be show where for a given price, the investment yield can be calculated as follows (see investment yield formula, Lecture 2), Where: i = investment yield Re = “expected return” F = face value P = market price

7. Points Along the Bond Demand Curve Demand for 1 year bond, assuming price of $950.  i = (1,000-950/950) = 5.3%  Assume at this price (and yield) 100 bonds will be demanded. this will be point A on the demand schedule. Demand assuming price of $900  i = (1,000-900/900) = 11.1%  Assume at this price (and yield) 200 bonds will be demanded This will be point B on the demand schedule Note: Market will hold more of the bond as its price decreases (as expected yield increases).

8. Additional Points Along the Demand Curve Point C:P = $850i = 17.6%B d = 300 Point D:P = $800i = 25.0%B d = 400 Point E:P = $750i = 33.0%B d = 500 Demand Curve is B d in Figure 1 which connects points A, B, C, D, E Demand Curve has a downward slope!  As the price of the bond decreases, demand for the bond will increase (see movement along the x axis; next slide).  Why: As the price decreases, the yield increases!

9. Figure 1: Demand Curve (Bd) Demand Curve is Bd connecting points A, B, C, D, E. Has a downward slope. As the price of the bond decreases (and the yield increases), demand (for bonds) will increase (along the x axis).

10. Derivation of the Supply Curve Supply Curve: shows the relationship between the quantity of a bond supplied and the price, when all other factors are held constant. Point F:P = $750i = 33.0%B s = 100 Point G:P = $800i = 25.0%B s = 200 Point C:P = $850i = 17.6%B s = 300 Point H:P = $900i = 11.1%B s = 400 Point I:P = $950i = 5.3%B s = 500 Supply Curve has upward slope!  As the price of the bond increases, supply will increase (along the x axis).  Why: The yield (cost to borrow) decreases.

11. Figure 2: Supply Curve (Bs) Supply Curve is Bs that connects points F, G, C, H, and I. Has upward slope. As the price of the bond increases (and the yield decreases), supply (of bonds) will increase (along the x axis).

12. Bond Market Equilibrium Bond Market Equilibrium: occurs when the amount of bonds an economy is willing to buy (demand) equals the amount of bonds an economy is willing to sell (supply).  Called the market-clearing price. Bond Market disequilibrium (i.e., excess demand or excess supply) is corrected through price changes!

13. Restoring Market Equilibrium 1. Occurs when B d = B s, at P* = 850, i* = 17.6% (Point C) 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*

14. Shifts in the Bond Demand and Supply Schedules Up to this point, we have examined what will cause a movement along (up or down) a bond demand and bond supply curve.  There is only one factor: Changes in the price of the bond. Now we need to examine, what will cause either schedule to shift (inward or outward)  And in response to factors other than a change in the price of the bond. When one of the schedules changes, this produces a change in the economy’s equilibrium interest rate.

15. Shifts in the Demand and Supply Curves The analysis of interest rate behavior (i.e., changes in the market equilibrium interest rate) needs to explore why the curves shift in or out!

16. Factors Causing the Demand Schedule to Shift Outward Wealth: When the economy grows, wealth increases. Increased wealth will result in a higher demand for bonds (in investor portfolios).  During a business expansion, the demand for bonds will increase. Risk: If prices in the bond market become less volatile (i.e., as the risk decreases), bonds will become more attractive and the demand for bonds will rise.  In addition, as alternative financial assets (e.g., stocks) become more risky, the demand for bonds will rise.

17. Factors Causing the Demand Schedule to Shift Outward Expected Returns on Bonds: If the interest rate is expected to be lower in the future (than it is now), the demand for bonds will increase now:  Why: If interest rates do fall in the future, the prices of currently held bonds will rise.  In addition, if expected returns on alternative financial assets falls (e.g., stocks), the demand for bonds will increase

18. Factors Causing the Demand Schedule to Shift Liquidity: Increases in the liquidity of bonds (marketability in secondary markets) will cause bonds to be more attractive, and increase the demand.  In addition, decreases in the liquidity of alternative financial assets, causes the demand for bonds to increase Expected Rate of Inflation: Decreases in the expected rate of inflation, will result in an increase in the real return on bonds, and cause the demand for bonds to increase.

19. Summary of Demand Factors 1. Wealth  Wealth , B d shifts out to right 2. Expected Return  R e for bonds (in the future) , B d shifts out to the right. 3. Risk  Risk of bonds , B d shifts out to right  Risk of other assets , B d shifts out to right 4. Liquidity  Liquidity of bonds , B d shifts out to right  Liquidity of other assets , B d shifts out to right 5. Expected Inflation  π e , real return , B d shifts out to right

20. Factors that Cause the Supply Schedule to Shift Outward Expected Profitability of Business Investment Opportunities: The greater the expected profit by business firms on their investments, the more willing they are to borrow.  Increase borrowing = increase in the supply of bonds.  Generally occurs during a business expansion.

21. Factors that Cause the Supply Schedule to Shift Outward Expected Inflation: When expected inflation increases, the real cost of borrowing decreases.  As the real cost of borrowing falls, firms increase their borrowing.  Increase borrowing = increase in the supply of bonds. Government Policies: Higher government deficits increases the need to borrow.  Increase borrowing = increase in the supply of bonds.

22. Summary of Supply Factors 1. Expected Profitability of Business Investment  Profitability , Bs shifts out to right 2. Expected Inflation π e , real cost of borrowing , Bs shifts out to right 3. Government Policies  Government deficits , B s shifts out to right

23. Adding the Rest of the World Foreign sector activity can result in shifts in another country’s demand and supply curves. Assume the U.S. financial market:  Inward investment from overseas will shift the demand schedule (for bonds) out.  Inward borrowing from overseas will shift the supply schedule (for bonds) out. Need to consider the impact of a global financial market on changes in a country’s equilibrium interest rate.

24. Loanable Funds Model Defined: A framework whereby we analyze the quantity of “loans” in the economy to explain interest rate changes. Loans = amount of funds supplied or demanded.  Demand for bonds = supply of loanable funds  Supply of bonds = demand for loanable funds

25. Changes in the Market’s Equilibrium Interest Rate Decreasing rate results from either:  Increase in the demand for bonds (increase in the supply of loanable funds)  Decrease in the supply of bonds (decrease in the demand for loanable funds) Increasing rate results from either:  Decrease in the demand for bonds (decrease in the supply of loanable funds)  Increase in the supply of bonds (increase in the demand for loanable funds)

26. Changes in the Equilibrium Interest Rate: Rate Falling

27. Changes in the Equilibrium Interest Rate: Rate Rising

28. Additional Considerations: The Fisher Effect Explanation of the market rate of interest. States that the market rate of interest is the sum of the real interest rate plus the expected rate of inflation.  The desired real rate of interest reflects the rate of real economic growth (i.e., the amount of reward that should accrue to the lender for lending to a productive economy).  An inflation premium is built in to nominal interest rates protect against this loss of purchasing power.

29. Changes in Market Interest Rates Over time, changes in market interest rates may be attributed to changes either in  the real desired rate 'r* or  due to changes in inflationary expectations. Changes in the desired real rate reflects the behavior in the market for loanable funds in response to changing economic activity (real economic activity). Changes in inflationary expectations tends to be a more complicated matter. One may hypothesize that current inflationary expectations are based on the history of past actual rates of inflation.  Called Adaptive Expectations model.

30. Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2004 Evidence on the Fisher Effect in the United States: 1953-2004

31. Additional Consideration However, at the time the debt contract is priced the inflation premium is based on expected rates of future inflation. If these expectations differ from actual inflation rates during the life of the debt instrument either the lender or borrower can be adversely affected.

32. Business Cycles and Short Term Interest Rates: U.S. Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2001 Note: Shaded areas are business contractions and white areas are business expansions

33. Business Cycles and Long Term Rates: U.S.

34. Observations Interest rates generally move in a “pro-cyclical” manner (with variable lags). Generally we observe:  Moving down in a business recession.  Moving up in a business expansion. Why?  Business cycle impacts  Central bank impacts Note: Inflationary environment can affect the cyclical move.  1970s: High and rising inflationary expectations in economy.  1980s – 1990s: falling and eventually low inflationary expectations in the economy.

35. Federal Funds Rate: 1955 - 1985

36. Federal Funds Rate: 1985 - Present

37. Example of Pro-Active Federal Funds Rate Changes in Late 2000