CHAPTER 15 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Financial Markets and Expectations Prepared by: Fernando Quijano and Yvonn Quijano

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 33 Bond Prices and Bond Yields Bonds differ in two basic dimensions:  Default risk, the risk that the issuer of the bond will not pay back the full amount promised by the bond.  Maturity, the length of time over which the bond promises to make payments to the holder of the bond. Bonds of different maturities each have a price and an associated interest rate called the yield to maturity, or simply the yield. 15-1

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 33 Bond Prices and Bond Yields U.S. Yield Curves: November 1, 2000 and June 1, 2001 The yield curve, which was slightly downward sloping in November 2000, was sharply upward sloping seven months later. The relation between maturity and yield is called the yield curve, or the term structure of interest rates. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 33 Government bonds are bonds issued by government agencies. Corporate bonds are bonds issued by firms. Bond ratings are issued by Standard and Poor’s Corporation and Moody’s Investors Service. The risk premium is the difference between the interest rate paid on a given bond and the interest rate paid on the bond with the highest rating. The Vocabulary of Bond Markets

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 33 Bonds with high default risk are often called junk bonds. Bonds that promise a single payment at maturity are called discount bonds. The single payment is called the face value of the bond. Bonds that promise multiple payments before maturity and one payment at maturity are called coupon bonds. The payments are called coupon payments. The Vocabulary of Bond Markets

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 33 The ratio of the coupon payments to the face value of the bond is called the coupon rate. The current yield is the ratio of the coupon payment to the price of the bond. The life of a bond is the amount of time left until the bond matures. The Vocabulary of Bond Markets

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 33 U.S. government bonds classified by maturity: Treasury bills, or T-bills: Up to one year. Treasury notes: One to ten years. Treasury bonds: Ten years or more. Bonds typically promise to pay a sequence of fixed nominal payments. However, other types of bonds, called indexed bonds, promise payments adjusted for inflation rather than fixed nominal payments. The Vocabulary of Bond Markets

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 33 Bond Prices as Present Values Consider two types of bonds:  A one-year bond—a bond that promises one payment of $100 in one year.  A two-year bond—a bond that promises one payment of $100 in two years. Price of the one-year bond: Price of the two-year bond:

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 33 Arbitrage and Bond Prices Returns from Holding 1-Year and 2-Year Bonds for 1 Year Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 33 Arbitrage and Bond Prices If you hold a two-year bond, the price at which you will sell it next year is uncertain—risky. For every dollar you put in one-year bonds, you will get (1+ i 1t ) dollars next year. For every dollar you put in two-year bonds, you can expect to receive $1/$P 2t times $P e 1t+1 dollars next year.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 33 Arbitrage and Bond Prices The expectations hypothesis states that investors care only about expected return. If two bonds offer the same expected one-year return, then: Expected return per dollar from holding a two-year bond for one year. Return per dollar from holding a one-year bond for one year.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 33 Arbitrage and Bond Prices Arbitrage relations are relations that make the expected returns on two assets equal. Arbitrage implies that the price of a two-year bond today is the present value of the expected price of the bond next year. The price of a one-year bond next year will depend on the one-year rate next year.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 33 Arbitrage and Bond Prices Given and, then: In words, the price of two-year bonds is the present value of the payment in two years— discounted using current and next year’s expected one-year interest rate.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 33 From Bond Prices to Bond Yields The yield to maturity on an n-year bond, or the n-year interest rate, is the constant annual interest rate that makes the bond price today equal to the present value of future payments of the bond., then: therefore: From here, we can solve for i 2t.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 33 From Bond Prices to Bond Yields The yield to maturity on a two-year bond, is closely approximated by: In words, the two-year interest rate is the average of the current one-year interest rate and next year’s expected one-year interest rate. Long-term interest rates reflect current and future expected short-term interest rates.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 33 Interpreting the Yield Curve An upward sloping yield curve means that long- term interest rates are higher than short-term interest rates. Financial markets expect short- term rates to be higher in the future. A downward sloping yield curve means that long- term interest rates are lower than short-term interest rates. Financial markets expect short- term rates to be lower in the future. Using the following equation, you can fine out what financial markets expect the 1-year interest rate to be 1 year from now:

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 33 The Yield Curve and Economic Activity The U.S. economy as of November 2000 In November 2000, the U.S. economy was operating above the natural level of output. Forecasts were for a “ soft landing,” a return of output to the natural level of output, and a small decrease in interest rates. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 33 The Yield Curve and Economic Activity The U.S. Economy from November 2000 to June 2001 From November 2000 to June 2001, an adverse shift in spending, together with a monetary expansion, combined to lead to a decrease in the short-term interest rate. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 33 The Yield Curve and Economic Activity From this figure, you can see the two major developments:  The adverse shift in spending was stronger than had been expected. Instead of shifting from IS to IS’ as forecast, the IS curve shifted by much more, to IS’’.  Realizing that the slowdown was stronger than it had anticipated, the Fed shifted in early 2001 to a policy of monetary expansion, leading to a downward shift in the LM curve.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 33 The Yield Curve and Economic Activity The Expected Path of the U.S. Economy as of June 2001 In June 2001, financial markets expected stronger spending and tighter monetary policy to lead to higher short- term interest rates in the future. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 33 The Yield Curve and Economic Activity Financial markets expected two main developments:  They expected a pickup in spending-a shift of the IS curve to the right, from IS to IS’.  They also expected that, once the IS curve started shifting to the right and output started to recover, the Fed would start shifting back to a tighter monetary policy.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 33 The Stock Market and Movements in Stock Prices Firms raise funds in two ways: Through debt finance —bonds and loans; and Through equity finance, through issues of stocks—or shares. Bonds pay predetermined amounts; stocks pay dividends from the firm’s profits. 15-2

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 33 The Stock Market and Movements in Stock Prices Standard and Poor’s Stock Price Index, in Real Terms since 1980 Nominal stock prices have multiplied by 25 since Real stock prices have only multiplied by 4. Real stock prices went through a slump until the late 1980s. Only since then have they grown rapidly. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 33 Stock Prices as Present Values The price of a stock must equal the present value of future expected dividends, or the present value of the dividend next year, of two years from now, and so on: In real terms,

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 33 Stock Prices as Present Values This relation has two important implications:  Higher expected future real dividends lead to a higher real stock price.  Higher current and expected future one-year real interest rates lead to a lower real stock price.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 33 The Stock Market and Economic Activity Stock prices follow a random walk if each step they take is as likely to be up as it is to be down. Their movements are therefore unpredictable. Even though major movements in stock prices cannot be predicted, we can still do two things:  We can look back and identify the news to which the market reacted.  We can ask “what if” questions.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 33 A Monetary Expansion and the Stock Market An Expansionary Monetary Policy and the Stock Market A monetary expansion decreases the interest rate and increases output. What it does to the stock market depends on whether financial markets anticipated the monetary expansion. Figure

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 33 An Increase in Consumer Spending and the Stock Market An Increase in Consumption Spending and the Stock Market The increase in consumption spending leads to a higher interest rate and a higher level of output. What happens to the stock market depends on the slope of the LM curve and on the Fed’s behavior. Figure 15 –8 (a)

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard29 of 33 An Increase in Consumer Spending and the Stock Market An Increase in Consumption Spending and the Stock Market If the LM curve is flat, the interest rate increases little, and output increases a lot. Stock prices go up. If the LM curve is steep, the interest rate increases a lot, and output increases little. Figure 15 – 8(b)

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard30 of 33 An Increase in Consumer Spending and the Stock Market An Increase in Consumption Spending and the Stock Market If the Fed accommodates, the interest rate does not increase, but output does. Stock prices go up. If the Fed decides instead to keep output constant, the interest rate increases, but output does not. Stock prices go down. Figure 15 – 8(c)

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard31 of 33 An Increase in Consumer Spending and the Stock Market There are several things the Fed may do after receiving news of strong economic activity:  They may accommodate, or increase the money supply in line with money demand so as to avoid an increase in the interest rate.  They may keep the same monetary policy, leaving the LM curve unchanged causing the economy to move along the LM curve  Or the Fed may worry that an increase in output above Y A may lead to an increase in inflation. Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday, and Other Stories Try to make sense of these quotes from The Wall Street Journal.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard32 of 33 Bubbles, Fads, and Stock Prices Stock prices are not always equal to their fundamental value, or the present value of expected dividends. Rational speculative bubbles occur when stock prices increase just because investors expected them to. Deviations of stock prices from their fundamental value are called fads Famous Bubbles: From Tulipmania in Seventeenth- Century Holland to Russia in Two accounts of fads, tulips and worthless stocks, that eventually flopped.

Chapter 15: Financial Markets and Expectations © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard33 of 33 Key Terms  default risk  maturity  yield curve  term structure of interest rates  government bonds  corporate bonds  bond ratings  risk premium  junk bonds  discount bonds  face value  coupon bonds  coupon payments  coupon rate  current yield  life (of a bond)  Treasury bills, or T-bills Treasury bills, or T-bills  Treasury notes  Treasury bonds  indexed bonds  expectations hypothesis  arbitrage  yield to maturity, or n-year interest rate  soft landing  debt finance  equity finance  shares, or stocks  dividends  random walk  Fed accommodation  fundamental value  rational speculative bubbles  fads