Lecture The Behavior of Interest Rates Chapter 5

Motivation Monetary Policy works primarily by manipulating interest rates Interest rates are determined in the bond market by the demand and supply for bonds Interest rates change because of shifts in demand and supply for bonds

Interest Rates on Selected Bonds, 1950–2015 Three things this graph demonstrates?? 3-month Bill 10-year Treasury 10-year Corporate Baa 3

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.

Bonds as a Financial Asset Demand for Financial Assets Wealth - the total resources owned by the individual, including all assets Expected Return - the return expected over the next period on one asset relative to alternative assets Risk - the degree of uncertainty associated with the return on one asset relative to alternative assets Liquidity - the ease and speed with which an asset can be turned into cash relative to alternative assets

Demand for Financial Assets Holding all other factors constant, the demand for an asset is: positively related to wealth positively related to its expected return relative to alternative assets negatively related to the risk of its returns relative to alternative assets positively related to its liquidity relative to alternative assets

Demand and Supply Curves for Bonds At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds (lenders) is higher - an inverse relationship At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds (borrowers) is lower - a positive relationship

This example is for a one-year zero coupon bond

Market Equilibrium Occurs 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

How Factors Shift the Demand Curve Wealth/saving As economy grows, income and wealth increase Bd  => Bd shifts out to right As economy contracts, income and wealth fall Bd , => Bd shifts in to left

How Factors Shift the Demand Curve Expected Returns on bonds If 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)

How Factors Shift the Demand Curve 3. Expected Returns on other assets As the expected return on other asset increase relative to return for long-term bonds Bonds become less attractive Bd shifts in to left (decrease in demand)

How Factors Shift the Demand Curve 4. Risk - Risk of bonds , Bd  Bd shifts out to right Risk of other assets , Bd 

How Factors Shift the Demand Curve 5. Liquidity Liquidity of bonds , Bd  Bd shifts out to right Liquidity of other assets , Bd 

Shift in the Demand Curve for Bonds

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 falls Expected Inflation: an increase in expected inflation causes the supply of bonds to increase Government Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds

Shift in the Supply Curve for Bonds

Case Study - Response to an Expected Increase in the Rate of Inflation 18

Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2011

FIGURE 7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2008

Response to a Business Cycle Expansion 21

What Happened in May 2013?

What happened here?

Loanable Funds - Use of Funds Approach 1. Demand for bonds = supply of loanable funds 2. Supply of bonds = demand for loanable funds

Liquidity Preference Framework proposed by John Maynard Keynes. from the perspective of ‘money’ assume there are 2 assets: bond + money = total wealth

The Liquidity Preference Framework two assets: bonds + money = total wealth supply side: Ms + Bs = Wealth demand side: Bd + Md = Wealth  Ms + Bs = Bd + Md Re-arranging:  Ms – Md = Bd – Bs Conclusion: 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

Keynesian Liquidity Preference Analysis Derivation of Demand Curve As i , the opportunity cost of holding money   Md . The demand curve for money has the usual downward slope Derivation of Supply curve Assume that central bank controls Ms and it is a fixed amount. Ms curve is vertical line Market Equilibrium Occurs when Md = Ms

Equilibrium in the Market for Money

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*

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 right Price-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

Increase in Income or the Price Level

Shifts in the Supply of Money The supply of money is controlled by the central bank An increase in the money supply by the Federal Reserve will shift the supply curve for money to the right

Response to an Increase in Money Supply

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

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).

Read Mishkin Carefully - Note the shift from “money supply” to “growth in the money supply”. Price-Level Effect and Expected-Inflation Effect A 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

Read Mishkin Carefully - Note the shift from “money supply” to “growth in the money supply” Price-Level Effect and Expected-Inflation Effect Expected-inflation effect persists only as long as the price level continues to rise which requires continued money growth. 37

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.

When Does Higher Money Growth Lower Interest Rates?