Lecture 3 Bonds SD BB

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8/2/2019 Lecture 3 Bonds SD BB

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ECO 210 Money and Banking

Prof. Sagiri Kitao

3. Supply and Demand in the Bond Market

Main concepts

y What determines the interest rates?

1. Supply and demand approach The demand and supply curves for bonds.

Market equilibrium where the supply meets the demand.

Interest rates are negatively correlated with bond prices. Hence what

determines the bond prices determines the interest rates.

2. Liquidity preference framework

Demand for Assets

y What are some of the factors that might influence the

demand for assets in general (bond, stock, real estate, etc)?

Determinants of asset demand

y Wealth [ ]

y Expected returns [ ]

(relative to alternative assets)

Risk of asset returns [ ]

y Liquidity [ ]

Relationship to asset demand:

Positive or negative?

Risk and asset demand

y AssetA: pays a fixed return of 10%. (less risky)

y Asset B: pays a return of 5% half the time and 15% the other

half of the time. (more risky)

Both assets offer the same expected return but they present

different degrees of risks.

A risk-averse person (most people) prefers to

hold less

risky asset and a risk-loving person prefers to hold more

risky asset.

Liquidity

y Liquidity of an asset:

How quickly an asset can be converted into cash at low costs

(easiness to sell)

Liquid assets: U.S. treasury bills

Less liquid assets: houses

y More liquidity is a plus since it is easier to find a buyer when

it·s time to sell.

Theory of asset demand: summary

The quantity demanded of an asset is:

1. Positively related to wealth.

2. Positively related to its expected return relative toalternative assets.

3. Negatively related to the risk of its returns relative to

alternative assets.

4. Positively related to its liquidity relative to alternativeassets.

Bond demand curve

Bond demand curveGraphical representation of the relationship between the

quantity of the bond demanded and the price when all

other economic variables are held constant (ceteris

paribus).

Bond demand curve

The quantity demanded will be lower, when the price

of the bond is higher.

The demand curve is downward-sloping, showing the

negative relationship between the price of bonds and

quantity of bonds demanded.

When the price is higher (i.e. the interest rate is lower), it isless attractive to buy bonds and the demand falls.

Bond demand curvePrice of bonds, P ($)

Quantity of bonds, B ($ billions)

200 300

Bond supply curve

Bond supply curveGraphical representation of the relationship between the

quantity of the bond supplied and the price when all

other economic variables are held constant (ceteris

paribus).

Bond supply curve

The quantity supplied will be higher, when the price of

the bond is higher.

The supply curve is upward-sloping, showing a positiverelationship between the price of bonds and quantity of

bonds supplied.

When the price is high (i.e. the interest rate is low), it is less

costly to borrow and firms are more willing to issue and supply(sell) bonds.

Bond supply curvePrice of bonds, P ($)

200 300

Bond market equilibrium

demand

supply

Bond market equilibriumPrice of bonds, P ($)

Supply curve

Demand curve

Equilibrium

Bond price and interest rate

Bond market equilibrium

y Off the equilibrium, the market tends to head toward and

settle at the equilibrium.

y What if the supply exceeds the demand? [Excess supply] There is a supply of bonds left unsold without buyers.

The price will fall.

y What if the demand exceeds the supply? [Excess demand]

There is a demand for bonds unfilled without sellers.The price will rise.

Supply curve

Demand curve

Excess supply at

price $900

200 300

Supply curve

Demand curve

Excess demand at

price $800

200 300

Changes in EquilibriumInterest Rates

Changes in the interest rates

Why do the interest rates change? Distinguish between

y Movements along a demand (or supply) curve

The change in quantity demanded (or supplied) as a result of achange in the price (or interest rates).

y Shifts in a demand (or supply) curve

The change in quantity demanded (or supplied) at each given

price in response to a change in some other factor besidethe price.

Changes in the interest rate

Shift in thedemand curve

Movement along

the demand curve

Factors that shift the demand curve

Factor

Relation to the bond

demand

Shift in demand when

the factor RISES

Wealth Positive Shift-out to the right

Expected returns Positive Shift-out to the right

Risk of returns Negative Shift-in to the left

Liquidity Positive Shift-out to the right

Shifts in the demand curve: examples

Example Change in the factor

Shift in demand

when the factor rises

Business cycle expansion(boom) Increase in wealth

ift-out to th

e righ

Increase in expected interest

Fall in expected return Shift-in to the left

Increase in expected inflation Fall in expected return relative

to alternative assets

Shift-in to the left

Increase in the volatility of

bond prices

Rise in the risk of bonds Shift-in to the left

Increase in the volatility of

stock prices

Fall in the risk of bonds relative

to alternative assets

Shift-out to the right

Factors that shift the supply curve

Factor

Relation to

the bond supply

Shift in supply when the

factor RISES

Expected profitability of investments

Positive Shift-out to t

he rig

Expected inflation Positive Shift-out to the right

Government deficit Positive Shift-out to the right

What happens to the bond market equilibrium when

expected inflation rises?

Answer

The price falls and interest rate rises: ´The Fisher effectµ

Expected inflation and interest rates

What happens to the bond demand and supply when expected

inflation rises?

1. Bond demand

The expected return from bonds relative to alternatives(real assets) falls.

The demand curve shifts to the left.

2. Bond supply

Implies a fall in the real interest rate and a decline in thecost of borrowing.

The supply curve shift to the right.

y The Fisher effect

When expected inflation rises, interest rates will rise.

The rise in expected inflation is good news for borrowers (lower

borrowing cost) and bad news for lenders (lower expected returns).

There are more supply and less demand, which both reduce the price

in equilibrium (i.e. higher interest rate).

Expected inflation and interest rates (3-months T-bills)

Money Market Equilibrium:Liquidity Preference Framework

Liquidity preference framework

y Liquidity preference framework developed by

John Maynard Keynes

A model of money demand and supply

An alternative framework that explains the equilibrium interest

Equivalence of liquidity preference framework

and bond market equilibrium

y Equating supply and demand for bonds is equivalent to

equating supply and demand for money in liquidity

preference framework.

y Two frameworks are closely linked, but differ in practice

because liquidity preference assumes only two assets,

money and bonds, and ignores effects on interest rates fromchanges in expected returns on real assets.

Liquidity preference analysis

y The money demand curve

Keynes defined money as currency and checking account

deposits that earn a zero rate of return.

As the interest rate rises, the opportunity cost of holding moneyincreases.Therefore, the demand for money falls.

The demand curve is downward sloping.

y The money supply curve

Assume that central bank controls the money supply and it is afixed amount.

The money supply curve is a vertical line.

Money market equilibrium

Money supply :

A vertical line

Money demand:

Downward sloping

Excess demand at i = 5%

Excess supply at i = 25%

Shifts in the money demand

y Income effectA rise in income Money demand increases since the value of moneyincreases as a medium of exchange (more transactions)and a store of value (more wealth to hold)

y Price level effectA rise in the price level Money demand increases to maintain the level of money

holdings in real terms

the demand curve shifts out to the right

Shifts in the money demand

Shifts in the money supply

y An increase in the money supply by the central bank (the

Federal Reserve) shifts the money supply curve to the right.

Shifts in the money supply

Summary of shifts

Change in the

variable

Change in money

demand or supply

Change in the

interest rate

Income

Price level

Money supply

Money supply and interest rates

y Prediction of the liquidity preference analysis

An increase in the money supply (everything else being

equal) lowers interest rates: ´liquidity effectµ.

But the change in the money supply could generate other effects

and affect the interest rate.

Money supply and interest rates

Effect of higher money growth

yEffect of higher rate of money growth on interestrates is ambiguous

Because income, price level and expected inflation effects work

in opposite direction of liquidity effect

Money growth and interest rates (1950-2008)

Lecture 3 Bonds SD BB

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