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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
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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
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Demand for Assets
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y What are some of the factors that might influence the
demand for assets in general (bond, stock, real estate, etc)?
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Determinants of asset demand
y Wealth [ ]
y Expected returns [ ]
(relative to alternative assets)
y
Risk of asset returns [ ]
y Liquidity [ ]
Relationship to asset demand:
Positive or negative?
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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.
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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.
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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.
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Bond demand curve
y
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).
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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.
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Bond demand curvePrice of bonds, P ($)
Quantity of bonds, B ($ billions)
A
B
900
800
200 300
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Bond supply curve
y
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).
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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.
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Bond supply curvePrice of bonds, P ($)
Quantity of bonds, B ($ billions)
D
C
900
800
200 300
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Bond market equilibrium
y
Bond
demand
Bond
supply
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Bond market equilibriumPrice of bonds, P ($)
Quantity of bonds, B ($ billions)
E
850
250
Supply curve
Demand curve
Equilibrium
price
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Bond price and interest rate
y
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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.
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Bond market equilibriumPrice of bonds, P ($)
Quantity of bonds, B ($ billions)
850
250
Supply curve
Demand curve
900
Excess supply at
price $900
200 300
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Bond market equilibriumPrice of bonds, P ($)
Quantity of bonds, B ($ billions)
850
250
Supply curve
Demand curve
800
Excess demand at
price $800
200 300
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Changes in EquilibriumInterest Rates
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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.
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Changes in the interest rate
Shift in thedemand curve
Movement along
the demand curve
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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
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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
Sh
ift-out to th
e righ
t
Increase in expected interest
rate
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
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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
ht
Expected inflation Positive Shift-out to the right
Government deficit Positive Shift-out to the right
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What happens to the bond market equilibrium when
expected inflation rises?
Answer
The price falls and interest rate rises: ´The Fisher effectµ
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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.
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Expected inflation and interest rates
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Expected inflation and interest rates
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Expected inflation and interest rates
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).
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Expected inflation and interest rates (3-months T-bills)
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Money Market Equilibrium:Liquidity Preference Framework
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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
rate
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Liquidity preference framework
y
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Liquidity preference framework
y
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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.
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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.
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Money market equilibrium
Money supply :
A vertical line
Money demand:
Downward sloping
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Money market equilibrium
y
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Money market equilibrium
Excess demand at i = 5%
Excess supply at i = 25%
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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
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Shifts in the money demand
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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.
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Shifts in the money supply
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Summary of shifts
Change in the
variable
Change in money
demand or supply
Change in the
interest rate
Income
Price level
Money supply
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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.
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Money supply and interest rates
y
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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
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Money growth and interest rates (1950-2008)