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Lecture 4

Lecture 4. UNDERSTANDING INTEREST RATES (2). The behavior of interest rates. What determines the quantity demanded of an asset? Wealth (total resources owned) Expected return of one asset relative to alternative assets Risk (the degree of uncertainty associated with the return)

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Lecture 4

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  1. Lecture 4 UNDERSTANDING INTEREST RATES (2)

  2. The behavior of interest rates • What determines the quantity demanded of an asset? • Wealth (total resources owned) • Expected return of one asset relative to alternative assets • Risk (the degree of uncertainty associated with the return) • Liquidity (the ease and speed with which an asset can be turned into cash)

  3. The demand for bonds • We consider a one-year discount bond, paying the owner the face value of €1,000 in one year. • If the holding period is one year, the return on the bond is equal the interest rate i. • It means: i = r = (F-P)/P • If the bond price is €950, r = 5.3% • We assume a quantity demanded at that price of €100 billion.

  4. The demand for bonds • If the price falls, say to €900, the interest rate increases (to 11.1%). • Because the return on the bond is higher, the demand for the asset will rise, say to €200 billion, etc.

  5. 950 5.3 900 11.1 17.6 850 800 25.0 750 33.0 The demand for bonds Price of bond (€) Interest rate (%) 500 200 300 400 100

  6. 950 5.3 900 11.1 17.6 850 800 25.0 750 33.0 The supply for bonds Price of bond (€) Interest rate (%) 500 200 300 400 100

  7. 950 5.3 900 11.1 850 17.6 800 25.0 750 33.0 Market equilibrium (asset market approach) Price of bond (€) Interest rate (%) C i* P* 500 200 300 400 100

  8. Market equilibrium • Equilibrium occurs at point C, where demand and supply curves intersect. • P* is the market-clearing price, and i* is the market-clearing interest rate. • If the P  P*, there is “excess supply” or “excess demand” of bonds. • The supply and demand curves can be brought into a more conventional form:

  9. 33.0 25.0 17.6 11.1 5.3 A reinterpretation of the bond market Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  10. Why do interest rates change? • If there is a shift in either the supply or demand curve, the equilibrium interest rate must change. • What can cause the curves to shift? • Wealth • Expected return • Risk • Liquidity

  11. Example: Increase in risk, and demand for bonds • If the risk of a bond increases, the demand for bonds will fall for any level of interest rates. • It means that the supply of loanable funds is reduced. • It is equivalent to a leftward shift of the supply curve.

  12. 33.0 25.0 17.6 11.1 5.3 A shift of the supply curve of funds Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls D C Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  13. Effects on the supply of funds for bonds Shift in supply curve Change invariable Change ininterest rate Change inquantity

  14. The supply of bonds • Some factors can cause the supply curve for bonds to shift, among them • The expected profitability of investment opportunities • Expected inflation • Government activities

  15. Example: Higher profitability and supply of bonds • If the profitability of a firm increases, the supply for corporate bonds will increase for any level of interest rates. • It means that the demand of loanable funds increases. • It is equivalent to a rightward shift of the demand curve.

  16. 33.0 25.0 17.6 11.1 5.3 A shift of the demand curve for funds Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls D C Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  17. Effects on the demand of funds for bonds Shift in demand curve Change invariable Change ininterest rate Change inquantity

  18. Expected inflation: The “Fisher effect” • If expected inflation increases, both curves are affected: • The supply of bonds (demand for funds) shifts to the right • The demand for bonds (supply of funds for bonds) shifts to the left • When expected inflation increases, the interest rate will rise (“Fisher effect”).

  19. 33.0 25.0 17.6 11.1 5.3 The “Fisher effect” Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls D C Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  20. Government activities • If government expands its debt (level of assets), this is tantamount to increasing its demand for loanable funds. • It will increase the interest rate. • In order to contain this effect, the EU member states have introduced the “Maastricht budget criteria”: • Level of government debt < 60% of GDP • Annual budget deficit < 3% of GDP

  21. Maastricht budget criteria: Comparison

  22. France and Germany

  23. The Maastricht budget criteria • The purpose is to limit the impact of government borrowing on interest rates. • France, and Germany are violating the deficit criterion. • Violation of the criteria may entail sanctions (fines)

  24. The market for EMU government bonds (1997)

  25. Supply and demand for money • An alternative model to the loanable funds theory is the model developed by J.M. Keynes: the liquidity preference theory. • It determines the equilibrium rate of interest in terms of supply and demand for money. John Maynard Keynes(1883-1946)

  26. Starting point of liquidity preference • There are only two assets that people use to store wealth: money and bonds. • It implies that Wealth = B + M , or Bs + Ms = Bd + Md , or Bs - Bd = Md - Ms • If the money market is in equilibrium, the bond market is also in equilibrium. • Keynes assumes that money earns no interest.

  27. Opportunity costs of money • The amount of interest (expected return) sacrificed by not holding the alternative asset (here: bond) represents the opportunity costs of holding money. • As interest rate rise (ceteris paribus), the expected return on money falls relative to the expected return on bonds. • As these cost of holding money increase,the demand for money falls.

  28. 33.0 25.0 17.6 11.1 5.3 Equilibrium in the market for money Interest rate (%) Supply of money, Ms C Demand for money, Md 500 200 300 400 100

  29. Shifts in the demand for money curve • Keynes considers two reasons why the demand for money curve could shift: • income; • and the price level • As income rises • wealth increases and people want to hold more money as a store of value • people want to carry out more transactions using money.

  30. Income and price-level effect • A higher level of income causes the demand for money to increase and the demand curve to shift to the right. • Changes in the price level: Keynes took the view that people care about the real value of money. • If the price level increases, the real value of money falls: • People want to hold a greater amount of money to restore their holdings in real terms.

  31. 33.0 25.0 17.6 11.1 5.3 Response to a change in income Interest rate (%) Supply of money, Ms D C Demand for money, Md 500 200 300 400 100

  32. Response to a change in the money supply • It is assumed that the central bank controls the total amount of money available. • The supply of money is “totally inelastic”. • However the central bank can gear the money supply by political intervention. • If the money supply increases, the interest rate will fall (liquidity effect).

  33. 33.0 25.0 17.6 11.1 5.3 Response to a change in money supply Interest rate (%) Supply of money, Ms D C Demand for money, Md 500 200 300 400 100

  34. Secondary effects of increased money supply • If the money supply increases this has a secondary effect on money demand • As we have seen: • it has an expansionary effect on the economy and raises income and wealth. -> interest rates increase (income effect). • it causes the overall price level to increase-> interest rates increase (price effect). • it affects the expected inflation rate-> interest rates increase (Fisher-effect).

  35. Should the ECB lower interest rates? • Politicians often ask the ECB to expand the money supply in order to promote a cyclical upturn(to combat unemployment). • The liquidity effect does in fact reduce the level of interest rates! • But the induced effects on money demand, • the income effect, • the price-level effect, and • the expected inflation effect all increase the level of interest rates.

  36. 33.0 25.0 17.6 11.1 5.3 Increase of money supply plus demand shift Interest rate (%) Supply of money, Ms E D C Demand for money, Md 500 200 300 400 100

  37. Growth of money (M3)

  38. Short-term interest rates

  39. Longer-term interest rates

  40. Interest rate spreads • “The” interest rate is an abstraction. In the real world there are many interest rates. • Interest rates differ notably with respect to the maturity of the underlying loan. • Long-term interest rates are less affected by short-term monetary policy. • They typically attract a higher return than short-term lending.

  41. The term structure of interest rates (USA)

  42. The term structure for MFI interest rates

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