Chapter 5. The Behavior of Interest Rates

1. Chapter 5. The Behavior of Interest Rates • asset demand • bond market • money demand and supply

2. I. Asset demand • which asset to choose? • depends on RELATIVE comparisons between choices

3. A. Wealth • greater wealth, greater resources wealth Qd of assets • holding other factors constant

4. B. Expected returns • based on expected cash flows, price changes Exp ret. of asset Qd of that asset • holding other factors constant

5. C. Risk • variation in asset’s return • people are risk averse • prefer lower risk if other factors the same risk of asset Qd of that asset • holding other factors constant

6. D. Liquidity • how easy is asset to convert to cash? • Tbill = easy • real estate = hard liquidity of asset Qd of that asset • holding other factors constant

7. II. The Bond Market A. Bond Demand • bond buyers/ lenders/ savers • look at Qd as a function of expected return, price

8. example • 1 year, zero coupon bond • YTM = exp. return

9. Bond Price i = exp. return 700 42.86% 750 33.33% 800 25% 850 17.65% 900 11.11% 950 5.26%

10. Exp ret. of bond Qd of bonds • so bond demand slopes down with respect to price price of bond Qd of bonds

11. Bond demand

12. shifts in bond demand • a change in wealth demand for bonds (shift rt.) wealth

13. a change in exp. interest rates • rising interest rates decrease value of existing bonds int. rates expected to demand for bonds (shift left)

14. a change in expected inflation • rising inflation decreases real return inflation expected to demand for bonds (shift left)

15. a change in the risk of bonds relative to other assets relative risk of bonds demand for bonds (shift left)

16. a change in liquidity of bonds relative to other assets relative liquidity of bonds demand for bonds (shift rt.)

17. B. Bond supply • bond issuers/ borrowers • look at Qs as a function of price, yield

18. lower bond prices • higher bond yields • more expensive to borrow • lower Qs of bonds • so bond supply slopes up with price

19. bond supply

20. shifts in bond supply • a change in expected profits • affects incentives to expand production supply of bonds (shift rt.) exp. profits • exp. economic expansion shifts bond supply rt.

21. a change in expected inflation • rising inflation decreases real cost of borrowing supply of bonds (shift rt.) exp. inflation

22. a change in government borrowing • deficits increase Treasury issues • surpluses decrease Treasury issues supply of bonds (shift rt.) deficits

23. demand for bonds = supply of loanable funds • supply of bonds = demand for loanable funds

24. C. Equilibrium interest rates • changes when bond demand shifts, and/or bond supply shifts • causes of shifts cause interest rates to change

25. Example 1: the Fisher effect • expected inflation 3%

26. exp. inflation rises to 4% • bond demand -- real return declines -- Bd decreases • bond supply -- real cost of borrowing declines -- Bs increases

27. bond price falls • interest rate rises

28. Fisher effect • expected inflation rises, nominal interest rates rise

29. Example 2: economic slowdown

30. bond demand • decline in income, wealth • Bd decreases • P falls, i rises • bond supply • decline in exp. profits • Bs decreases • P rises, i falls

31. shift Bs > shift in Bd • interest rate falls

32. Why shift Bs > shift Bd? • changes in wealth are small • response to change in exp. profits is large • large cyclical swings in investment

34. example 6 • how does bond market explain behavior of 30 yr. Treasury yield? • 2000-2001 • 30 yr. yield < 10 yr. yield • Usually, -- 30 yr > 10 yr

36. Why the switch? • Bond supply • Treasury cut back on 30 yr issues -- due to budget surplus • Bs decreases for 30 yr. Tbonds -- price rises, yield falls • Bs of 10 yr. Tnotes not affected

38. II. Liquidity Preference • money demand & money supply

39. 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

40. interest rate is opportunity cost of holding money • higher interest rate, hold less money • money demand slopes down with respect to interest rate

41. money demand

42. what shifts Md? • a change in income • income increase, buy more stuff save more money -- Md increases (shift rt.)

43. a change in price level • prices increase, need more money to buy same amount of stuff -- Md increases

44. a change in technology • ATM/ debit cards -- hold less cash -- easier access to savings -- hold less M1 -- Md decreases

45. B. Money supply • controlled by central bank • Federal Reserve System • assume complete control • Ms is vertical

46. Md and Ms

47. what shifts Ms? • a change in Federal Reserve policy • Fed increases Ms • Fed decreases Ms • Fed has several tools to do this -- chapter 17

48. C. Money & Interest Rates • shifts in Md and/or Ms • changes in interest rate

49. example 3 • economic expansion increases income • interest rate rises

50. example 4 • economic expansion increases prices • interest rate rises