2. The Behavior of Interest Rates
Chapter Four
The Behavior of Interest Rates

3. Determinants of Asset Demand

4. Benefits of Diversification
Diversification almost always beneficial to risk-averse investor
Less returns of securities move together, greater is risk reduction from diversification

5. Derivation of Demand Curve
Point A
Point B

6. Derivation of Demand Curve
Point C: P = $850 i = 17.6% Bd = 300
Point D: P = $800 i = 25.0% Bd = 400
Point E: P = $750 i = 33.0% Bd = 500
Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E.
Has usual downward slope

7. Supply and Demand Analysis of the Bond Market
Figure 4-1: Supply and Demand for Bonds

8. Derivation of Supply Curve
Point F: P = $750 i = 33.0% Bs = 100
Point G: P = $800 i = 25.0% Bs = 200
Point C: P = $850 i = 17.6% Bs = 300
Point H: P = $900 i = 11.1% Bs = 400
Point I: P = $950 i = 5.3% Bs = 500
Supply Curve is Bs that connects points F, G, C, H, I, and has upward slope

9. Market Equilibrium Occurs when Bd = Bs, at P* = 850, i* = 17.6%
When P = $950, i = 5.3%, Bs > Bd (excess supply): P  to P*, i  to i*
When P = $750, i = 33.0, Bd > Bs (excess demand): P  to P*, i  to i*

10. Loanable Funds Terminology
Demand for bonds = supply of loanable funds
Supply of bonds = demand for loanable funds
Figure 4-2: A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

11. Shifts in the Demand Curve
Figure 4-3: Shifts in the Demand Curve for Bonds

12. How Factors Shift the Demand Curve
Wealth
Economy , wealth , Bd , Bd shifts out to right
Expected Return
i  in future, Re for long-term bonds , Bd shifts out to right
πe , relative Re , Bd shifts out to right
Risk
Risk of bonds , Bd , Bd shifts out to right
Risk of other assets , Bd , Bd shifts out to right
Liquidity
Liquidity of bonds , Bd , Bd shifts out to right
Liquidity of other assets , Bd ,Bd shifts out to right

13. Factors That Shift Demand Curve

14. Shifts in the Supply Curve
Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right
Expected Inflation
πe , Bs , Bs shifts out to right
Government Activities
Deficits , Bs , Bs shifts out to right
Figure 4-4: Shift in the Supply Curve for Bonds

15. Factors That Shift Supply Curve

16. Changes in πe: The Fisher Effect
If πe 
Relative Re , Bd shifts in to left
Bs , Bs shifts out to right
P , i 
Figure 4-5: Response to a Change in Expected Inflation

17. Evidence on the Fisher Effect in the United States
Figure 4-6: Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2001

18. Business Cycle Expansion
Wealth , Bd , Bd shifts out to right
Investment , Bs , Bs shifts right
If Bs shifts more than Bd then P , i 
Figure 4-7: Response to a Business Cycle Expansion

19. Evidence on Business Cycles and Interest Rates
Figure 4-8: Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2001

20. Relation of Liquidity Preference Framework to Loanable Funds
Keynes’s Major Assumption
Two categories of assets in wealth
money
bonds
Thus: Ms + Bs = Wealth
Budget constraint: Bd + Md = Wealth
Therefore: Ms + Bs = Bd + Md
Subtracting Md and Bs from both sides: Ms  Md = Bd  Bs

21. Relation of Liquidity Preference Framework to Loanable Funds
Money Market Equilibrium
Occurs when Md = Ms
Then Md  Ms = 0 which implies that Bd  Bs = 0, so that Bd = Bs and bond market is also in equilibrium

22. Relation of Liquidity Preference Framework to Loanable Funds
Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money in liquidity preference framework
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

23. Liquidity Preference Analysis
Derivation of Demand Curve
Keynes assumed money has i = 0
As i , relative Re on money  (equivalently, opportunity cost of money )  Md 
Demand curve for money has usual downward slope
Derivation of Supply curve
Assume that central bank controls Ms and is a fixed amount
Ms curve is vertical line

24. Liquidity Preference Analysis
Market Equilibrium
Occurs when Md = Ms, at i* = 15%
If i = 25%, Ms > Md (excess supply): Price of bonds , i  to i* = 15%
If i =5%, Md > Ms (excess demand): Price of bonds , i  to i* = 15%

25. Money Market Equilibrium
Figure 4-10: Equilibrium in the Market for Money

26. Rise in Income Income , Md , Md shifts out to right Ms unchanged
i* rises from i1 to i2
Figure 4-11: Response to a Change in Income

27. Rise in Price Level Price level , Md , Md shifts to right
Ms unchanged
i* rises from i1 to i2
Figure 4-12: Response to a Change in Price Level
Current inflation statistics
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

28. Rise in Money Supply Ms , Ms shifts out to right Md unchanged
i* falls from i1 to i2
Figure 4-13: Response to a Change in the Money Supply
Current money supply figures

30. Money and Interest Rates
Effects of money on interest rates
Liquidity Effect
Ms , Ms shifts right, i 
Income Effect
Ms , Income , Md , Md shifts right, i 
Price Level Effect
Ms , Price level , Md , Md shifts right, i 
Expected Inflation Effect
Ms , πe , Bd , Bs , Fisher effect, i 

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

32. Does Higher Money Growth Lower Interest Rates?
Figure 4-14: Response over Time to an Increase in Money Supply Growth

33. Evidence on Money Growth and Interest Rates
Figure 4-15: Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2001

34. Profiting from Interest-Rate Forecasts
Methods for forecasting
Loanable funds: use Flow of Funds Accounts and judgment
Econometric Models: large in scale, use liquidity preference
Make decisions about assets to hold
Forecast i , buy long bonds
Forecast i , buy short bonds
Make decisions about how to borrow
Forecast i , borrow short
Forecast i , borrow long

35. Supply and Demand in Gold Market
Deriving Demand Curve
Pet+1 is held constant
Pt , ge , Re   Gd 
Demand curve is downward sloping
Deriving Supply Curve
Pt , more production, Gs 
Supply curve is upward sloping

36. Supply and Demand in Gold Market
Market Equilibrium
Gd = Gs
If Pt > P* = P1, Gs > Gd, Pt  to P*
If Pt < P* = P1, Gs < Gd, Pt  to P*

37. Changes in Equilibrium
Factors That Shift Demand Curve for Gold
Wealth
Expected return on gold relative to alternative assets
Riskiness of gold relative to alternative assets
Liquidity of gold relative to alternative assets
Factors That Shift Supply Curve for Gold
Technology of mining
Government sales of gold

38. Response of Gold Market to a Change in πe
If πe 
πe , Pet+1 ; at given Pt, ge   Gd   Gd shifts right
Go to point 2; Pt 
Price of gold positively related to πe
Gold price is barometer of π- pressure
Figure 4-A1: A Change in the Equilibrium Price of Gold