Chapter Four The Behaviour of Interest Rates
Copyright © 2004 Pearson Education Canada Inc. Slide 4–3 Determinants of Asset Demand
Copyright © 2004 Pearson Education Canada Inc. Slide 4–4 Benefits of Diversification 1.Diversification almost always beneficial to risk-averse investor 2.Less returns of securities move together, greater is risk reduction from diversification
Copyright © 2004 Pearson Education Canada Inc. Slide 4–5 Point B Derivation of Demand Curve Point A
Copyright © 2004 Pearson Education Canada Inc. Slide 4–6 Derivation of 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. –Has usual downward slope
Copyright © 2004 Pearson Education Canada Inc. Slide 4–7 Supply and Demand Analysis of the Bond Market Figure 1: Supply and Demand for Bonds
Copyright © 2004 Pearson Education Canada Inc. Slide 4–8 Derivation of Supply Curve 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 is B s that connects points F, G, C, H, I, and has upward slope
Copyright © 2004 Pearson Education Canada Inc. Slide 4–9 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*
Copyright © 2004 Pearson Education Canada Inc. Slide 4–10 Loanable Funds Terminology 1.Demand for bonds = supply of loanable funds 2.Supply of bonds = demand for loanable funds Figure 2: A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds
Copyright © 2004 Pearson Education Canada Inc. Slide 4–11 Shifts in the Demand Curve Figure 3: Shifts in the Demand Curve for Bonds
Copyright © 2004 Pearson Education Canada Inc. Slide 4–12 How Factors Shift the Demand Curve 1.Wealth –Economy , wealth , B d , B d shifts out to right 2.Expected Return –i in future, R e for long-term bonds , B d shifts out to right –π e , relative R e , B d shifts out to right 3.Risk –Risk of bonds , B d , B d shifts out to right –Risk of other assets , B d , B d shifts out to right 4.Liquidity –Liquidity of bonds , B d , B d shifts out to right –Liquidity of other assets , B d ,B d shifts out to right
Factors That Shift Demand Curve Copyright © 2004 Pearson Education Canada Inc. Slide 4–13
Copyright © 2004 Pearson Education Canada Inc. Slide 4–14 Shifts in the Supply Curve 1.Profitability of Investment Opportunities –Business cycle expansion, investment opportunities , B s , Bs shifts out to right 2.Expected Inflation –π e , B s , B s shifts out to right 3.Government Activities –Deficits , B s , B s shifts out to right Figure 4: Shift in the Supply Curve for Bonds
Factors That Shift Supply Curve Copyright © 2004 Pearson Education Canada Inc. Slide 4–15
Copyright © 2004 Pearson Education Canada Inc. Slide 4–16 Changes in π e : The Fisher Effect If π e 1.Relative R e , B d shifts in to left 2.B s , B s shifts out to right 3.P , i Figure 5: Response to a Change in Expected Inflation
Copyright © 2004 Pearson Education Canada Inc. Slide 4–17 Evidence on the Fisher Effect Figure 6: U.S. Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2001
Copyright © 2004 Pearson Education Canada Inc. Slide 4–18 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 Figure 7: Response to a Business Cycle Expansion
Copyright © 2004 Pearson Education Canada Inc. Slide 4–19 Evidence on Business Cycles and Interest Rates
Copyright © 2004 Pearson Education Canada Inc. Slide 4–20 Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption –Two categories of assets in wealth money 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
Copyright © 2004 Pearson Education Canada Inc. Slide 4–21 Relation of Liquidity Preference Framework to Loanable Funds 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
Copyright © 2004 Pearson Education Canada Inc. Slide 4–22 Relation of Liquidity Preference Framework to Loanable Funds 1.Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money 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
Copyright © 2004 Pearson Education Canada Inc. Slide 4–23 Liquidity Preference Analysis Derivation of Demand Curve 1.Keynes assumed money has i = 0 2.As i , relative R e on money (equivalently, opportunity cost of money ) 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
Copyright © 2004 Pearson Education Canada Inc. Slide 4–24 Liquidity Preference Analysis 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%
Copyright © 2004 Pearson Education Canada Inc. Slide 4–25 Money Market Equilibrium Figure 10: Equilibrium in the Market for Money
Copyright © 2004 Pearson Education Canada Inc. Slide 4–26 Rise in Income 1.Income , M d , M d shifts out to right 2.M s unchanged 3.i* rises from i 1 to i 2 Figure 11: Response to a Change in Income
Copyright © 2004 Pearson Education Canada Inc. Slide 4–27 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 Figure 12: Response to a Change in Price Level
Copyright © 2004 Pearson Education Canada Inc. Slide 4–28 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 Figure 13: Response to a Change in the Money Supply Current money supply figures
Copyright © 2004 Pearson Education Canada Inc. Slide 4–29
Copyright © 2004 Pearson Education Canada Inc. Slide 4–30 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 , π e , B d , B s , Fisher effect, i
Copyright © 2004 Pearson Education Canada Inc. Slide 4–31 Money and Interest Rates Effect of higher rate of money growth on interest rates is ambiguous –Because income, price level and expected inflation effects work in opposite direction of liquidity effect
Does Higher Money Growth Lower Interest Rates? Figure 14: Response over Time to an Increase in Money Supply Growth Copyright © 2004 Pearson Education Canada Inc. Slide 4–32
Copyright © 2004 Pearson Education Canada Inc. Slide 4–33 Evidence on Money Growth and Interest Rates
Copyright © 2004 Pearson Education Canada Inc. Slide 4–34 Profiting from Interest-Rate Forecasts Methods for forecasting 1.Loanable funds: use Flow of Funds Accounts and judgment 2.Econometric Models: large in scale, use liquidity preference Make decisions about assets to hold 1.Forecast i , buy long bonds 2.Forecast i , buy short bonds Make decisions about how to borrow 1.Forecast i , borrow short 2.Forecast i , borrow long
Copyright © 2004 Pearson Education Canada Inc. Slide 4–35 Supply and Demand in Gold Market Deriving Demand Curve 1.P e t+1 is held constant 2.P t , g e , R e G d 3.Demand curve is downward sloping Deriving Supply Curve 1.P t , more production, G s 2.Supply curve is upward sloping
Copyright © 2004 Pearson Education Canada Inc. Slide 4–36 Supply and Demand in Gold Market 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*
Copyright © 2004 Pearson Education Canada Inc. Slide 4–37 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
Copyright © 2004 Pearson Education Canada Inc. Slide 4–38 Response of Gold Market to a Change in π e If π e 1.π e , P e t+1 ; at given P t, g e G d G d shifts right 2.Go to point 2; P t 3.Price of gold positively related to π e 4.Gold price is barometer of π- pressure Figure A1: A Change in the Equilibrium Price of Gold