1. Interest Rate Determination (ch4) -- Fin 331 1 Interest Rate Determination 1. Determinants of Asset Demand 2. Supply and Demand Analysis 3. Fisher Effect and Business Cycle Effect

2. Interest Rate Determination (ch4) -- Fin 331 2 Determinants of Asset Demand

3. Interest Rate Determination (ch4) -- Fin 331 3 Supply and Demand Analysis 1.Deriving supply and demand curves under a simple discount bond framework 2. Equilibrium 3. Loanable funds

4. Interest Rate Determination (ch4) -- Fin 331 4 Derivation of Demand Curve i = RET e = (F - P) P Point A: P = $950 i = B d = 100 (given) Point B: P = $900 i = B d = 200 (given) Assumption: other economic variables hold constant

5. Interest Rate Determination (ch4) -- Fin 331 5 Point C:P = $850 i = 17.6% B d = 300 Point D:P = $800 i = 25.0% B d = 400 Point E:P = $750 i = 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 -- consumers are willing to buy as price lower Derivation of Demand Curve

6. Interest Rate Determination (ch4) -- Fin 331 6 Derivation of Supply Curve Point F:P = $750 i = 33.0% B s = 100 Point G:P = $800 i = 25.0% B s = 200 Point C:P = $850 i = 17.6% B s = 300 Point H:P = $900 i = 11.1% B s = 400 Point I:P = $950 i = 5.3% B s = 500 Notice: suppliers are willing to supply more as price go up while the relationship between P and i is unchanged

7. Interest Rate Determination (ch4) -- Fin 331 7 Supply and Demand of Bond Market

8. Interest Rate Determination (ch4) -- Fin 331 8 1. Occurs when B d = B s, at P* = 850, i* = 17.6% 2. When P = $950, i = 5.3%, 3. When P = $750, i = 33.0, Market Equilibrium

9. Interest Rate Determination (ch4) -- Fin 331 9 Loanable Funds Terminology 1. Demand for bonds = supply of loanable funds 2. Supply of bonds = demand for loanable funds

10. Interest Rate Determination (ch4) -- Fin 331 10 Shifts in the Demand Curve

11. Interest Rate Determination (ch4) -- Fin 331 11 How Factors Shift the Demand Curve 1. Wealth A. Economy , wealth , B d , B d shifts out to right 2. Expected Return A. i  in future, RET e for long-term bonds , B d shifts out to right B. π e , relative RET e , B d shifts out to right 3. Risk A. Risk of bonds , B d , B d shifts out to right B. Risk of other assets , B d , B d shifts out to right 4. Liquidity A. Liquidity of bonds , B d , B d shifts out to right B. Liquidity of other assets , B d ,B d shifts out to right

12. Interest Rate Determination (ch4) -- Fin 331 12 Shifts in the Supply Curve 1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , B s , B s 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

13. Interest Rate Determination (ch4) -- Fin 331 13 Changes in π e : the Fisher Effect If π e  1. Relative RET e , B d shifts in to left 2. B s , B s shifts out to right 3. P , i 

14. Interest Rate Determination (ch4) -- Fin 331 14 Evidence on the Fisher Effect in the United States

15. Interest Rate Determination (ch4) -- Fin 331 15 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 

16. Interest Rate Determination (ch4) -- Fin 331 16 Evidence on Business Cycles and Interest Rates