Chapter Four

The Behavior of Interest Rates

Slide 4–3

Determinants of Asset Demand

Slide 4–4

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

Slide 4–5

• Point B

i Re F P

P

P $950

i $1000 $950

$950.053 5.3%

Bd 100

P $900

i $1000 $900

$900.111 11.1%

Bd 200

Derivation of Demand Curve

• Point A

Slide 4–6

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

Slide 4–7

Supply and Demand Analysis of the Bond Market

Figure 4-1: Supply and Demand for Bonds

Slide 4–8

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

Slide 4–9

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*

Slide 4–10

Loanable Funds Terminology

1. Demand for bonds = supply of loanable funds

2. Supply of bonds = demand for loanable funds

Figure 4-2: A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

Slide 4–11

Shifts in the Demand Curve

Figure 4-3: Shifts in the Demand Curve for Bonds

Slide 4–12

How Factors Shift the Demand Curve

1. Wealth– Economy , wealth , Bd , Bd shifts out to right

2. Expected Return– i in future, Re for long-term bonds , Bd shifts out to right– πe , relative Re , Bd shifts out to right

3. Risk– Risk of bonds , Bd , Bd shifts out to right– Risk of other assets , Bd , Bd shifts out to right

4. Liquidity– Liquidity of bonds , Bd , Bd shifts out to right– Liquidity of other assets , Bd ,Bd shifts out to right

Factors That Shift Demand Curve

Slide 4–14

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 rightFigure 4-4: Shift in the Supply Curve for Bonds

Factors That Shift Supply Curve

Slide 4–16

Changes in πe: The Fisher Effect

• If πe 1. Relative Re ,

Bd shifts in to left

2. Bs , Bs shifts out to right

3. P , i

Figure 4-5: Response to a Change in Expected Inflation

Slide 4–17

Evidence on the Fisher Effect in the United States

Figure 4-6: Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2001

Slide 4–18

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

Figure 4-7: Response to a Business Cycle Expansion

Slide 4–19

Evidence on Business Cycles and Interest Rates

Figure 4-8: Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2001

Slide 4–20

Relation of Liquidity Preference Framework to Loanable Funds

• Keynes’s Major Assumption– Two categories of assets in wealth

• money

• 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

Slide 4–21

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

Slide 4–22

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

Slide 4–23

Liquidity Preference Analysis

• Derivation of Demand Curve1. Keynes assumed money has i = 02. As i , relative Re on money

(equivalently, opportunity cost of money ) Md 3. Demand curve for money has usual downward slope

• Derivation of Supply curve1. Assume that central bank controls Ms and is a fixed

amount2. Ms curve is vertical line

Slide 4–24

Liquidity Preference Analysis

• Market Equilibrium1. 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%

Slide 4–25

Money Market Equilibrium

Figure 4-10: Equilibrium in the Market for Money

Slide 4–26

Rise in Income

1. Income , Md , Md shifts out to right

2. Ms unchanged

3. i* rises from i1 to i2

Figure 4-11: Response to a Change in Income

Slide 4–27

Rise in Price Level

1. Price level , Md , Md shifts to right

2. Ms unchanged

3. i* rises from i1 to i2

Figure 4-12: Response to a Change in Price Level

Current inflation statisticsftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Slide 4–28

Rise in Money Supply

1. Ms , Ms shifts out to right

2. Md unchanged

3. i* falls from i1 to i2

Figure 4-13: Response to a Change in the Money Supply

Current money supply figureshttp://www.federalreserve.gov/releases/h6/current

Slide 4–30

Money and Interest Rates

• Effects of money on interest rates1. Liquidity Effect

Ms , Ms shifts right, i

2. Income EffectMs , Income , Md , Md shifts right, i

3. Price Level EffectMs , Price level , Md , Md shifts right, i

4. Expected Inflation EffectMs , πe , Bd , Bs , Fisher effect, i

Slide 4–31

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

Does Higher Money Growth Lower Interest Rates?

Figure 4-14: Response over Time to an Increase in Money Supply Growth

Slide 4–33

Evidence on Money Growth and Interest Rates

Figure 4-15: Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2001

Slide 4–34

Profiting from Interest-Rate Forecasts

• Methods for forecasting1. Loanable funds: use Flow of Funds Accounts and judgment2. Econometric Models: large in scale, use liquidity preference

• Make decisions about assets to hold1. Forecast i , buy long bonds2. Forecast i , buy short bonds

• Make decisions about how to borrow1. Forecast i , borrow short2. Forecast i , borrow long

Slide 4–35

Supply and Demand in Gold Market

• Deriving Demand Curve

Re Pt1

e Pt

Pt

ge

1. Pet+1 is held constant

2. Pt , ge , Re Gd

3. Demand curve is downward sloping

• Deriving Supply Curve1. Pt , more production, Gs

2. Supply curve is upward sloping

Slide 4–36

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*

Slide 4–37

Changes in Equilibrium

• Factors That Shift Demand Curve for Gold1. 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 Gold1. Technology of mining

2. Government sales of gold

Slide 4–38

Response of Gold Market to a Change in πe

• If πe 1. πe , Pe

t+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

Figure 4-A1: A Change in the Equilibrium Price of Gold