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Chapter 5. The Behavior of Interest Rates

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1 Chapter 5. The Behavior of Interest Rates
asset demand bond market money demand and supply

2 I. Asset demand which asset to choose?
depends on RELATIVE comparisons between choices

3 A. Wealth wealth Qd of assets greater wealth, greater resources
holding other factors constant

4 B. Expected returns Exp ret. of asset Qd of that asset
based on expected cash flows, price changes Exp ret. of asset Qd of that asset holding other factors constant

5 C. Risk risk of asset Qd of that asset variation in asset’s return
people are risk averse prefer lower risk if other factors the same risk of asset Qd of that asset holding other factors constant

6 D. Liquidity liquidity of asset Qd of that asset
how easy is asset to convert to cash? Tbill = easy real estate = hard liquidity of asset Qd of that asset holding other factors constant

7 II. The Bond Market A. Bond Demand bond buyers/ lenders/ savers
look at Qd as a function of expected return, price

8 example 1 year, zero coupon bond YTM = exp. return

9 Bond Price i = exp. return
% % % % % %

10 Exp ret. of bond Qd of bonds price of bond Qd of bonds
so bond demand slopes down with respect to price

11 Bond demand

12 shifts in bond demand demand for bonds wealth (shift rt.)
a change in wealth demand for bonds (shift rt.) wealth

13 int. rates demand for expected bonds to (shift left)
a change in exp. interest rates rising interest rates decrease value of existing bonds int. rates expected to demand for bonds (shift left)

14 inflation demand for expected bonds to (shift left)
a change in expected inflation rising inflation decreases real return inflation expected to demand for bonds (shift left)

15 relative risk of bonds demand for bonds (shift left)
a change in the risk of bonds relative to other assets relative risk of bonds demand for bonds (shift left)

16 relative demand for liquidity bonds of bonds (shift rt.)
a change in liquidity of bonds relative to other assets relative liquidity of bonds demand for bonds (shift rt.)

17 B. Bond supply bond issuers/ borrowers
look at Qs as a function of price, yield

18 lower bond prices higher bond yields more expensive to borrow lower Qs of bonds so bond supply slopes up with price

19 bond supply

20 shifts in bond supply supply of exp. bonds profits (shift rt.)
a change in expected profits affects incentives to expand production supply of bonds (shift rt.) exp. profits exp. economic expansion shifts bond supply rt.

21 supply of exp. bonds inflation (shift rt.)
a change in expected inflation rising inflation decreases real cost of borrowing supply of bonds (shift rt.) exp. inflation

22 supply of bonds deficits (shift rt.) a change in government borrowing
deficits increase Treasury issues surpluses decrease Treasury issues supply of bonds (shift rt.) deficits

23 demand for bonds = supply of loanable funds supply of bonds = demand for loanable funds

24 C. Equilibrium interest rates
changes when bond demand shifts, and/or bond supply shifts causes of shifts cause interest rates to change

25 Example 1: the Fisher effect
expected inflation 3%

26 exp. inflation rises to 4%
bond demand -- real return declines -- Bd decreases bond supply -- real cost of borrowing declines -- Bs increases

27 bond price falls interest rate rises

28 Fisher effect expected inflation rises, nominal interest rates rise

29 Example 2: economic slowdown

30 bond demand decline in income, wealth Bd decreases P falls, i rises bond supply decline in exp. profits Bs decreases P rises, i falls

31 shift Bs > shift in Bd
interest rate falls

32 Why shift Bs > shift Bd?
changes in wealth are small response to change in exp. profits is large large cyclical swings in investment

33

34 example 6 how does bond market explain
behavior of 30 yr. Treasury yield? 30 yr. yield < 10 yr. yield Usually, -- 30 yr > 10 yr

35

36 Why the switch? Bond supply Treasury cut back on 30 yr issues
-- due to budget surplus Bs decreases for 30 yr. Tbonds -- price rises, yield falls Bs of 10 yr. Tnotes not affected

37

38 II. Liquidity Preference
money demand & money supply

39 A. Money demand consider M1 assets earn little or no interest
holding money vs. bonds bonds earn interest money is more liquid -- holding money shows preference for liquidity

40 interest rate is opportunity cost of holding money
higher interest rate, hold less money money demand slopes down with respect to interest rate

41 money demand

42 what shifts Md? a change in income income increase, buy more stuff
save more money -- Md increases (shift rt.)

43 a change in price level prices increase, need more money to buy same amount of stuff -- Md increases

44 a change in technology ATM/ debit cards -- hold less cash -- easier access to savings -- hold less M1 -- Md decreases

45 B. Money supply controlled by central bank Federal Reserve System
assume complete control Ms is vertical

46 Md and Ms

47 what shifts Ms? a change in Federal Reserve policy Fed increases Ms
Fed decreases Ms Fed has several tools to do this -- chapter 17

48 C. Money & Interest Rates
shifts in Md and/or Ms changes in interest rate

49 example 3 economic expansion increases income interest rate rises

50 example 4 economic expansion increases prices interest rate rises

51 example 5 Federal Reserve increases Ms interest rate falls

52 Does an increase in Ms lower i ?
example 5 MS shifts right i falls this is called the liquidity effect, but it doesn’t stop there.

53 but lower i will lead to economic expansion
consumers borrow and buy firms borrow and invest income rises -- MD shifts right -- i rises

54 income effect liquidity effect income effect

55 economic expansion can lead to
higher prices increase MD and i

56 price level effect liquidity effect price level effect

57 expected inflation effect
if people expect increase in Ms, expect increase in P expect inflation Fisher effect increase in exp. inflation increase in i

58 total effect of increase in Ms?
depends on which effect is larger if liquidity effect is greater then i will fall if other effects are greater then i will rise

59 evidence? little evidence that liquidity effect dominates
perhaps in short-run increase in MS does not impact long-term rates as much as exp. inflation

60

61 In summary, interest rates determined by supply and demand bond market
money market shifts in demand/supply curves changes in general level of interest rates


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