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Chapter Four

Chapter Four. BEHAVIOR OF INTEREST RATES. Determinants of Asset Demand. Benefits of Diversification. 1. Diversification almost always beneficial to risk-averse investor 2. Less returns of securities move together, greater is risk reduction from diversification. Derivation of Demand Curve.

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Chapter Four

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  1. Chapter Four BEHAVIOR OF INTEREST RATES

  2. Determinants of Asset Demand

  3. Benefits of Diversification • 1. Diversification almost always beneficial to risk-averse investor • 2. Less returns of securities move together, greater is risk reduction from diversification

  4. Derivation of Demand Curve • i = RETe = (F - P) • P • Point A: P = $950 i = ($1000 - $950) = .053 = 5.3% $950 Bd = 100 • Point B: P = $900 i = ($1000 - $900) = .111 = 11.1% $900 Bd = 200

  5. 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

  6. Supply and Demand Analysis of the Bond Market

  7. 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

  8. Market Equilibrium • 1. Occurs when Bd = Bs, at P* = 850, i* = 17.6% • 2. When P = $950, i = 5.3%, Bs > Bd (excess supply): P to P*, i to i* • 3. When P = $750, i = 33.0, Bd > Bs (excess demand): P to P*, i to i*

  9. Loanable Funds Terminology • 1. Demand for bonds = supply of loanable funds • 2. Supply of bonds = demand for loanable funds

  10. Shifts in the Demand Curve

  11. How Factors Shift the Demand Curve • 1. Wealth A. Economy , wealth , Bd, Bd shifts out to right • 2. Expected Return A. i in future, RETe for long-term bonds , Bd shifts out to right B. πe, relative RETe, Bd shifts out to right • 3. Risk A. Risk of bonds , Bd, Bd shifts out to right B. Risk of other assets , Bd, Bd shifts out to right • 4. Liquidity A. Liquidity of bonds , Bd, Bd shifts out to right B. Liquidity of other assets , Bd,Bd shifts out to right (RETe)指現在的預期1年持有報酬率 指預期未來YTM會下降

  12. Factors that Shift Demand Curve

  13. Shifts in the Supply Curve • 1. Profitability of Investment Opportunities • Business cycle expansion, investment opportunities , Bs, Bs shifts out to right • 2. Expected Inflation • πe, Bs, Bs shifts out to right • 3. Government Activities • Deficits , Bs, Bs shifts out to right

  14. Factors that Shift Supply Curve

  15. Changes in π e: the Fisher Effect • If π e • 1. Relative RETe, Bd shifts in to left • 2. Bs, Bs shifts out to right • 3. P , i 

  16. Evidence on the Fisher Effect in the United States

  17. Business Cycle Expansion • 1. Wealth , Bd, Bd shifts out to right • 2. Investment , Bs, Bs shifts right • 3. If Bs shifts more than Bd then P, i

  18. Evidence on Business Cycles and Interest Rates 不景氣

  19. Relation of Liquidity Preference Framework to Loanable Funds • Keynes’s Major Assumption • Two categories of assets in wealth 1. money 2. bonds • 1. Thus: Ms + Bs = Wealth • 2. Budget constraint:Bd + Md = Wealth • 3. Therefore: Ms + Bs = Bd + Md • 4. Subtracting Md and Bs from both sides: • Ms - Md = Bd - Bs

  20. Relation of Liquidity Preference Framework to Loanable Funds • Money Market Equilibrium • 5. Occurs when Md = Ms • 6. Then Md - Ms = 0 which implies that Bd - Bs = 0, so that Bd = Bs and bond market is also in equilibrium

  21. Relation of Liquidity Preference Framework to Loanable Funds • 1. Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money in liquidity preference framework • 2. 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

  22. Liquidity Preference Analysis • Derivation of Demand Curve • 1. Keynes assumed money has i = 0 • 2. As i, relative RETe on money (equivalently, opportunity cost of money ) Md • 3. Demand curve for money has usual downward slope • Derivation of Supply curve • 1. Assume that central bank controls Ms and is a fixed amount • 2. Ms curve is vertical line

  23. Liquidity Preference Analysis • Market Equilibrium • 1. Occurs when Md = Ms, at i* = 15% • 2. If i = 25%, Ms > Md (excess supply): Price of bonds , i to i* = 15% • 3. If i =5%, Md > Ms (excess demand): Price of bonds , i to i* = 15%

  24. Money Market Equilibrium

  25. Rise in Income • 1. Income , Md, Md shifts out to right • 2. Ms unchanged • 3. i* rises from i1 to i2

  26. Rise in Price Level • 1. Price level , Md, Md shifts to right • 2. Ms unchanged • 3. i* rises from i1 to i2

  27. Rise in Money Supply • 1. Ms, Ms shifts out to right • 2. Md unchanged • 3. i* falls from i1 to i2

  28. Factors that Shift Money Demand and Supply Curves

  29. Money and Interest Rates • Effects of money on interest rates • 1. Liquidity Effect Ms, Ms shifts right, i • 2. Income Effect Ms, Income , Md, Md shifts right, i • 3. Price Level Effect Ms, Price level , Md, Md shifts right, i • 4. Expected Inflation Effect Ms, πe, Bd, Bs, Fisher effect, i

  30. 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

  31. Does Higher Money Growth Lower Interest Rates?

  32. Evidence on Money Growth and Interest Rates

  33. Profiting from Interest-Rate Forecasts • Methods for Forecasting 1. Loanable funds: use Flow of Funds Accounts and judgement 2. Econometric Models: large in scale, use liquidity preference • Make decisions about assets to hold 1. Forecast i , buy long bonds 2. Forecast i , buy short bonds • Make decisions about how to borrow 1. Forecast i , borrow short 2. Forecast i , borrow long

  34. Supply and Demand in Gold Market • Deriving Demand Curve • 1. Pet+1 is held constant • 2. Pt, ge, RETeGd • 3. Demand curve is downward sloping • Deriving Supply Curve • 1. Pt, more production, Gs • 2. Supply curve is upward sloping

  35. Supply and Demand in Gold Market • Market Equilibrium • 1. Gd = Gs • 2. If Pt > P* = P1, Gs > Gd, Pt to P* • 3. If Pt < P* = P1, Gs < Gd, Pt to P*

  36. Changes in Equilibrium • Factors that Shift Demand Curve for Gold • 1. Wealth • 2. Expected return on gold relative to alternative assets • 3. Riskiness of gold relative to alternative assets • 4. Liquidity of gold relative to alternative assets • Factors that Shift Supply Curve for Gold • 1. Technology of mining • 2. Government sales of gold

  37. Response of Gold Market to a Change in πe • If πe • 1.πe, Pet+1; at given Pt, geGdGd shifts right • 2. Go to point 2; Pt • 3. Price of gold positively related to πe • 4. Gold price is barometer of π-pressure

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