Presentation on theme: "Lecture The Behavior of Interest Rates"— Presentation transcript:
1 Lecture The Behavior of Interest Rates Chapter 5
2 MotivationMonetary Policy works primarily by manipulating interest ratesInterest rates are determined in the bond market by the demand and supply for bondsInterest rates change because of shifts in demand and supply for bonds
3 Interest Rates on Selected Bonds, 1950–2015 Three things this graph demonstrates?? 3-month Bill10-year Treasury10-year Corporate Baa3
4 We look at three perspectives on the bond market Bonds as financial assets: Theory of asset demand and asset allocation. S&D for Bonds.Loanable funds: Supply & Demand for loanable funds. Savings and Investment. Bond demand is one component of the aggregate supply of loanable funds.What’s being traded - Bonds or the use of funds?Liquidity Preference: View bonds as an alternative to holding money.
5 Bonds as a Financial Asset Demand for Financial Assets Wealth - the total resources owned by the individual, including all assetsExpected Return - the return expected over the next period on one asset relative to alternative assetsRisk - the degree of uncertainty associated with the return on one asset relative to alternative assetsLiquidity - the ease and speed with which an asset can be turned into cash relative to alternative assets
6 Demand for Financial Assets Holding all other factors constant, the demand for an asset is:positively related to wealthpositively related to its expected return relative to alternative assetsnegatively related to the risk of its returns relative to alternative assetspositively related to its liquidity relative to alternative assets
7 Demand and Supply Curves for Bonds At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds (lenders) is higher - an inverse relationshipAt lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds (borrowers) is lower - a positive relationship
9 Market EquilibriumOccurs when the quantity that people are willing to buy equals the quantity that people are willing to sell at a given price.Bd = Bs : the equilibrium or market clearing price and interest rate.When Bd > Bs : excess demand, investors will bid-up the price and interest rate will fall.When Bd < Bs : excess supply, sellers will lower the price and interest rate will rise
10 How Factors Shift the Demand Curve Wealth/savingAs economy grows, income and wealth increaseBd => Bd shifts out to rightAs economy contracts, income and wealth fallBd , => Bd shifts in to left
11 How Factors Shift the Demand Curve Expected Returns on bondsIf i is expected to fall in future, expected return for long-term bonds Bd shifts out to right (increase in demand)If i is expected to rise in future, expected return for long-term bonds Bd shifts in to left (decrease in demand)
12 How Factors Shift the Demand Curve 3. Expected Returns on other assetsAs the expected return on other asset increase relative to return for long-term bondsBonds become less attractiveBd shifts in to left (decrease in demand)
13 How Factors Shift the Demand Curve 4. Risk -Risk of bonds , Bd Bd shifts out to rightRisk of other assets , Bd
14 How Factors Shift the Demand Curve 5. LiquidityLiquidity of bonds , Bd Bd shifts out to rightLiquidity of other assets , Bd
16 Shifts in the Supply of Bonds Expected Profitability of Investment Opportunities:in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds fallsExpected Inflation:an increase in expected inflation causes the supply of bonds to increaseGovernment Activities:higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds
24 Loanable Funds - Use of Funds Approach 1. Demand for bonds = supply of loanable funds2. Supply of bonds = demand for loanable funds
25 Liquidity Preference Framework proposed by John Maynard Keynes.from the perspective of ‘money’assume there are 2 assets:bond + money = total wealth
26 The Liquidity Preference Framework two assets: bonds + money = total wealthsupply side: Ms + Bs = Wealthdemand side: Bd + Md = Wealth Ms + Bs = Bd + MdRe-arranging: Ms – Md = Bd – BsConclusion:If money market is in equilibrium (money demand equals money supply: Md = Ms ), then bond market is also in equilibrium (bond demand equals bond supply: Bd = Bs).Md - Ms
27 Keynesian Liquidity Preference Analysis Derivation of Demand CurveAs i , the opportunity cost of holding money Md . The demand curve for money has the usual downward slopeDerivation of Supply curveAssume that central bank controls Ms and it is a fixed amount. Ms curve is vertical lineMarket EquilibriumOccurs when Md = Ms
29 Market equilibrium equilibrium quantity of money: Md = Ms equilibrium interest rate: i*If i > i* , Ms > Md (excess supply of money)Central bank supply of money is greater than the amount of money people are willing to hold price of bonds , i back to i*If i < i*, Md > Ms (excess demand for money) price of bonds , i back to i*
30 Shifts in the Demand for Money Income Effect - a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the rightPrice-Level Effect - a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right
34 Does Everything Else Remain Equal? Liquidity preference framework says that an increase in the money supply will lower interest rates, if other things remain unchanged - the liquidity effect.Noble prize winner Milton Friedman argued:Over time, as the economy expands and income increases, get an Income Effect. The demand curve for money, Md , shifts to the right and interest rates begin to rise.34
35 Everything Else Remaining Equal (?) Also, over time, can get a Price Level effect. A rise in the price level causes demand curve for money to shift to the right which will cause interest rates to rise.There may also be an Expected-Inflation effect which causes an increase in interest rates because the increase in the money supply may lead people to expect a higher price level in the future (the demand curve shifts to the right).
36 Read Mishkin Carefully - Note the shift from “money supply” to “growth in the money supply” Price-Level Effect and Expected-Inflation EffectA one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices.A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero.36
37 Read Mishkin Carefully - Note the shift from “money supply” to “growth in the money supply” Price-Level Effect and Expected-Inflation EffectExpected-inflation effect persists only as long as the price level continues to rise which requires continued money growth.37
38 Money Supply Growth and the Effects on Interest Rates Liquidity Effect: Ms growth i Income Effect: i Income Md i Price Level Effect: Income Price level Md i Expected Inflation Effect: Ms Price level πe Bd Bs Fisher effect i What’s the net effect on interest rate?Effect of higher rate of money growth on interest rates is ambiguous.
39 When Does Higher Money Growth Lower Interest Rates?