Chapter 5. The Behavior of Interest Rates
Theory of Asset Demand
Loanable Funds Framework: bond market
Liquidity Preference Framework: money demand and supply
summary
Theory of Asset Demand
which asset to choose?
depends on RELATIVE comparisons between choices
Determinants of Asset Demand
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
A. Wealth
greater wealth, greater resources
holding other factors constant
wealth
Qd of assets
B. Expected returns
An increase in an asset’s exp to that of an alternative asset, raises the Qd of the asset.
holding other factors constant
Exp ret.
of asset
Qd of that
asset
C. Risk
people are risk averse
prefer lower risk if other factors are the same
holding other factors constant
risk of
asset
Qd of that
asset
D. Liquidity
how easily is an asset converted to cash?
T-bill = easy
real estate = hard
holding other factors constant
liquidity of
asset
Qd of that
asset
In summary
Loanable Funds Framework: the Bond Market
A. Bond Demand
bond buyers/ lenders/ savers
look at Qd as a function of expected return, price
example
1 year, zero coupon bond
YTM = exp. return
Bond Price i = exp. return
700 %
750 %
800 25%
850 %
900 %
950 %
so bond demand slopes down with respect to price
Exp ret.
of bond
Qd of
bonds
price
of bond
Qd of
bonds
Bond demand curve
shifts in bond demand curve
a change in wealth
wealth
demand for
bonds
(shift rt.)
a change in exp. interest rates
rising interest rates decrease value of existing bonds
int. rates
expected
to
demand for
bonds
(shift left)
a change in expected inflation
rising inflation decreases real return
inflation
expected
to
demand for
bonds
(shift left)
a change in the risk of bonds relative to other assets
relative
risk of
bonds
demand for
bonds
(shift left)
a change in liquidity of bonds relative to other assets
relative
liquidity
of bonds
demand for
bonds
(shift rt.)
B. Bond supply
bond issuers/ borrowers
look at Qs as a function of price, yield
lower bond prices
higher bond yields
more expensive to borrow
lower Qs of bonds
so bond supply slopes up with price
bond supply
shifts in bond supply curve
a change in expected profits
affects incentives to expand production
exp.
profits
supply of
bonds
(shift rt.)
exp. economic expansion shifts bond supply rt.
a change in expected inflation
rising inflation decreases real cost of borrowing
exp.
inflation
supply of
bonds
(shift rt.)
a change in government borrowing
deficits increase Treasury bonds issues
surpluses decrease Treasury bonds issues
deficits
supply of
bonds
(shift rt.)
demand for bonds
= supply of loanable funds
supply of bonds
= demand for loanable funds
C. Market Equilibrium
Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price
When Bd = Bs the equilibrium (or market clearing) price and interest rate
When Bd > Bs excess demand price will rise and interest rate will fall
When Bd < Bs excess supply price will fall and interest rate will rise
Example 1: the Fisher effect
expected inflation 3%
exp. inflation rises to 4%
bond demand
-- real return declines
-- Bd decreases
bond supply
-- real cost of borrowing declines
-- Bs increases
bond price falls
interest rate rises
Fisher effect
expected inflation rises,
nominal interest rates rise
Example 2: economic slowdown
bond demand
decline in income, wealth
Bd decreases
P falls, i rises
bond supply
decline in exp. profits
Bs decreases
P rises, i falls
shift Bs > shift in Bd
interest rate falls
Why shift Bs > shift Bd?
changes in wealth are small
response to change in exp. profits is large
large cyclical swings in investment
Example 3: economic expansion
Shaded areas indicate periods of recession.
. Liquidity Preference Framework
A. Money demand
consider M1
assets earn little or no interest
holding money vs. bonds
bonds earn interest
money is more liquid
-- holding money shows preference for liquidity
interest rate is opportunity cost of holding money
higher interest rate, hold less money
money demand slopes down with respect to interest rate
what shifts Md?
a change in income
income increase,
buy more stuff
save more money
-- Md increases (shift rt.)
a change in price level
prices increase,
need more money
to buy same amount of stuff
-- Md increases
B. Money supply
controlled by central bank
Federal Reserve System
assume complete control
Ms is vertical
Md and Ms
what shifts Ms?
a change in Federal Reserve policy
Fed increases Ms
Fed decreases Ms
Fed has several tools to do this
-- chapter 17
C. Money & Interest Rates
shifts in Md and/or Ms
changes in interest rate
example 1
economic expansion increases income
interest rate rises
economic expansion increases prices
interest rate rises
example 1
example 2
Federal Reserve increases Ms
interest rate falls
Does an increase in Ms lower i ?
In example 2
MS shifts right
i falls
this is called the liquidity effect(流动性效应),
BUT it doesn’t stop there.
lower i will lead to economic expansion
consumers borrow and buy
firms borrow and invest
income rises
-- MD shifts right
-- i rises
income effect（收入效应）
income effect
liquidity effect
price level effect(价格水平效应)
economic expansion can lead to
higher prices
increase Md and i
cont…
price level effect
liquidity effect
expected inflation effect（预期通货膨胀效应）
if people expect increase in Ms,
expect increase in P
expect inflation
Fisher effect
increase in exp. inflation
increase in i
total effect of increase in Ms?
depends on which effect is larger
if liquidity effect is greater
then i will fall
if other effects are greater
then i will rise
evidence?
little evidence that liquidity effect dominates
perhaps in short-run
increase in Ms does not impact long-term rates as much as exp. inflation
In summary,
interest rates determined by supply and demand
bond market
money market
shifts in demand/supply curves
changes in general level of interest rates
