Interest Rate Determination zThis chapter: What makes interest rates move up or down? zDo not confuse with: What makes interest rates different, such as secondary market, default risk, etc. zApply Demand and Supply analysis to bond market.

Summary Results: Shifts in Bond Demand zIncrease in Bond Demand: D B  (Rightward shift in Demand for Bonds) yD B   i*  zDecrease in Bond Demand: D B  (Leftward shift in Demand for Bonds) yD B   i* 

Shift Variables: Bond Demand zWealth -- increases in Wealth increase the Demand for Bonds zExpected Inflation (  e ),  e   D B   i* 

zReturn or Expected Return on Alternative Assets yInterest Rates on Bonds of Similar Maturity (for specific bond) yExpected Rate of Return on Stock (RET e ) yExpected future interest rates (i e ), i e   D B   i*  yInterest rates on foreign bonds

zMarket Risk of Bonds and Alternative Assets yMarket Risk of Bonds (  B )  B   D B   i*  yMarket Risk of Stock (  S )  S   D B   i* 

zChanges Affecting Structural Differences yChanges in Risk Rating of an individual firm (Default Risk) yChanges in Marginal Tax Rate -- affects the Demand for Municipal Bonds

Summary Results: Shifts in Bond Supply zIncrease in Bond Supply: S B  (Rightward shift in Supply of bonds) y S B   i*  zDecrease in Bond Supply: S B  (Leftward shift in Supply of bonds) yS B   i* 

Shift Variables: Supply of Bonds zExpected Inflation (  e ),  e   S B   i*  zSize of Deficits and National Debt Debt   S T-BILLS   i*  zSize of State and Local Government Debt Debt   S MUN   i* 

More Shift Variables: Bond Supply zDesire for Firms to Undertake Investment Projects Investment   S CORP   i*  zLoan Demand Faced by Banks Loan Demand   S CD   i* 

General Conclusions – Interest Rates zMany factors (not just the Federal Reserve) change interest rates. zInterest rate movements tend to be procyclical, or vary positively with the growth the economy.

The Federal Reserve and Interest Rates zFederal Reserve -- practices monetary policy through Open Market Operations, the buying or selling of bonds (generally T-Bills). zExpansionary Policy (addressing sluggish economy or recession): Fed buys bonds zContractionary Policy (addressing inflation): Fed sells bonds

Dual Effects: Monetary Policy zExample – Federal Reserve practices Expansionary Policy to try to improve sluggish economy zLiquidity Effect: Fed buys more bonds  D B   i*  zExpected Inflation Effect: Expansionary policy   e   i*  zOverall Effect --- Which one dominates?