chapter 5 financial systemsss.pdf

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Chapter 5

The Behavior of

Interest Rates


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2013 Pearson Education, Inc. All rights reserved.5-2

Determinants of Asset Demand

Wealth: the total resources owned by theindividual, including all assets

Expected Return: the return expected over the

next period on one asset relative to alternativeassets

Risk: the degree of uncertainty associated with thereturn on one asset relative to alternative assets

Liquidity: the ease and speed with which an assetcan be turned into cash relative to alternativeassets


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Theory of Portfolio Choice

Holding all other factors constant:

1. The quantity demanded of an asset is positively relatedto wealth

2. The quantity demanded of an asset is positively related

to its expected return relative to alternative assets

3. The quantity demanded of an asset is negatively relatedto the risk of its returns relative to alternative assets

4. The quantity demanded of an asset is positively related

to its liquidity relative to alternative assets


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Summary Table 1 Response of the Quantityof an Asset Demanded to Changes inWealth, Expected Returns, Risk, andLiquidity


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Supply and Demand in the BondMarket

At lower prices (higher interest rates),ceteris paribus, the quantity demanded ofbonds is higher: an inverse relationship

At lower prices (higher interest rates),ceteris paribus, the quantity supplied ofbonds is lower: a positive relationship


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Figure 1 Supply and Demand forBonds


7/30 2013 Pearson Education, Inc. All rights reserved.5-7

Market Equilibrium

Occurs when the amount that people arewilling to buy (demand) equals the amountthat people are willing to sell (supply) at agiven price

Bd = Bs defines the equilibrium (or marketclearing) price and interest rate.

When Bd > Bs , there is excess demand,

price will rise and interest rate will fall When Bd < Bs , there is excess supply,

price will fall and interest rate will rise



Changes in Equilibrium InterestRates

Shifts in the demand for bonds: Wealth: in an expansion with growing wealth, the

demand curve for bonds shifts to the right

Expected Returns: higher expected interest rates in

the future lower the expected return for long-termbonds, shifting the demand curve to the left

Expected Inflation: an increase in the expected rateof inflations lowers the expected return for bonds,causing the demand curve to shift to the left

Risk: an increase in the riskiness of bonds causesthe demand curve to shift to the left

Liquidity: increased liquidity of bonds results in thedemand curve shifting right



Figure 2 Shift in the DemandCurve for Bonds


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Summary Table 2 Factors That Shiftthe Demand Curve for Bonds


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Shifts in the Supply of Bonds

Expected profitability of investmentopportunities: in an expansion, the supplycurve shifts to the right

Expected inflation: an increase in expectedinflation shifts the supply curve for bonds tothe right

Government budget: increased budgetdeficits shift the supply curve to the right


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Summary Table 3 Factors ThatShift the Supply of Bonds


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Figure 3 Shift in the SupplyCurve for Bonds


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Figure 4 Response to a Changein Expected Inflation

i d fl i d


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Figure 5 Expected Inflation andInterest Rates (Three-Month TreasuryBills), 19532011

Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, The Real Interest Rate: An

Empirical Investigation, Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151200. These proceduresinvolve estimating expected inflation as a function of past interest rates, inflation, and time trends.


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Figure 6 Response to a BusinessCycle Expansion

Fi 7 B i C l d I t t


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Figure 7 Business Cycle and InterestRates (Three-Month Treasury Bills),19512011

Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.

S l d D d i th M k t f


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Supply and Demand in the Market forMoney: The Liquidity PreferenceFramework

Keynesian model that determines the equilibrium interest rate

in terms of the supply of and demand for money.

There are two main categories of assets that people use to store

their wealth: money and bos s d d

s d s d

s d

s d

nds.

Total wealth in the economy = B M = B + M

Rearranging: B - B = M - M

If the market for money is in equilibrium (M = M ),then the bond market is also in equilibrium (B = B ).


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Figure 8 Equilibrium in theMarket for Money


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Demand for Money in theLiquidity Preference Framework

As the interest rate increases:

The opportunity cost of holding moneyincreases

The relative expected return of moneydecreases

and therefore the quantity demanded ofmoney decreases.


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Changes in Equilibrium Interest Ratesin the Liquidity Preference Framework

Shifts in the demand for money:

Income Effect: a higher level of incomecauses the demand for money at each

interest rate to increase and the demandcurve to shift to the right

Price-Level Effect: a rise in the price level

causes the demand for money at eachinterest rate to increase and the demandcurve to shift to the right


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Shifts in the Supply of Money

Assume that the supply of money iscontrolled by the central bank

An increase in the money supply engineered

by the Federal Reserve will shift the supplycurve for money to the right


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Summary Table 4 Factors That Shiftthe Demand for and Supply of Money

i h


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Figure 9 Response to a Changein Income or the Price Level

i 0 Ch


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Figure 10 Response to a Changein the Money Supply

P i L l Eff


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Price-Level Effectand Expected-Inflation Effect

A one time increase in the money supply will cause prices torise to a permanently higher level by the end of the year. Theinterest rate will rise via the increased prices.

Price-level effect remains even after prices have stopped

rising.

A rising price level will raise interest rates because people willexpect inflation to be higher over the course of the year. Whenthe price level stops rising, expectations of inflation will returnto zero.

Expected-inflation effect persists only as long as the price levelcontinues to rise.


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Does a Higher Rate of Growth of theMoney Supply Lower Interest Rates?

Liquidity preference framework leads to theconclusion that an increase in the moneysupply will lower interest rates: the liquidity

effect. Income effect finds interest rates rising

because increasing the money supply is anexpansionary influence on the economy (thedemand curve shifts to the right).

Does a Higher Rate of Growth of the


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Does a Higher Rate of Growth of theMoney Supply Lower Interest Rates?

(contd)

Price-Level effect predicts an increase in themoney supply leads to a rise in interestrates in response to the rise in the price

level (the demand curve shifts to the right). Expected-Inflation effect shows an increase

in interest rates because an increase in themoney supply may lead people to expect a

higher price level in the future (the demandcurve shifts to the right).


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Figure 11Response overTime to anIncrease in Money

Supply Growth

Figure 12 Money Growth (M2 Annual


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2013 P Ed ti I All i ht d5 30

Figure 12 Money Growth (M2, AnnualRate) and Interest Rates (Three-MonthTreasury Bills), 19502011

Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

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