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Chapter 5. The Behavior of Interest Rates. asset demand bond market money demand and supply. I. Asset demand. which asset to choose? depends on RELATIVE comparisons between choices. A. Wealth. greater wealth, greater resources. wealth. Qd of assets. holding other factors constant.
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Chapter 5. The Behavior of Interest Rates • asset demand • bond market • money demand and supply
I. Asset demand • which asset to choose? • depends on RELATIVE comparisons between choices
A. Wealth • greater wealth, greater resources wealth Qd of assets • holding other factors constant
B. Expected returns • based on expected cash flows, price changes Exp ret. of asset Qd of that asset • holding other factors constant
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
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
II. 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 42.86% 750 33.33% 800 25% 850 17.65% 900 11.11% 950 5.26%
Exp ret. of bond Qd of bonds • so bond demand slopes down with respect to price price of bond Qd of bonds
shifts in bond demand • a change in wealth demand for bonds (shift rt.) wealth
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
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.
a change in expected inflation • rising inflation decreases real cost of borrowing supply of bonds (shift rt.) exp. inflation
a change in government borrowing • deficits increase Treasury issues • surpluses decrease Treasury issues supply of bonds (shift rt.) deficits
demand for bonds = supply of loanable funds • supply of bonds = demand for loanable funds
C. Equilibrium interest rates • changes when bond demand shifts, and/or bond supply shifts • causes of shifts cause interest rates to change
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
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 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
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
II. Liquidity Preference • money demand & money supply
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
a change in technology • ATM/ debit cards -- hold less cash -- easier access to savings -- hold less M1 -- Md decreases
B. Money supply • controlled by central bank • Federal Reserve System • assume complete control • Ms is vertical
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 3 • economic expansion increases income • interest rate rises
example 4 • economic expansion increases prices • interest rate rises