© 2008 Pearson Education Canada Chapter 5 The Behaviour of Interest Rates © 2008 Pearson Education Canada

There are 3 Models for Interest Rates Demand and Supply of Bonds Real Demand and Supply of Money Fisher Equation / Risk Premium Model © 2008 Pearson Education Canada

1. Supply and Demand for Bonds (Cont’d) © 2008 Pearson Education Canada

Supply and Demand for Bonds At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship. At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship. © 2008 Pearson Education Canada

Determining the Quantity Demanded of an Asset Wealth - the total resources owned by the individual, including all assets Expected Return - the return expected over the next period on one asset relative to alternative assets Risk - the degree of uncertainty associated with the return on one asset relative to alternative assets; including Expected Inflation Rate Liquidity - the ease and speed with which an asset can be turned into cash relative to alternative assets © 2008 Pearson Education Canada

Derivation of Bond Demand Curve i= RORe =RET = (F- P)/P Point A: Figure 5-1 P = $950 i= ($1000-$950)/$950 = 0.053 = 5.3% Bd = $100 billion © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Note that the F(face value of the bond) is always fixed, and that there is an inverse relationship between ROR and (market) P(price) of Bonds: When the bond price P falls, the ROR or RET should rise. © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Market Equilibrium Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. When Bd = Bs  the equilibrium (or market clearing) price and interest rate When Bd > Bs  excess demand  price will rise and interest rate will fall When Bd < Bs  excess supply  price will fall and interest rate will rise © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Theory of Asset Demand Holding all other factors constant: The quantity demanded of an asset is positively related to wealth. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets. © 2008 Pearson Education Canada

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-term bonds, shifting the demand curve to the left Expected Inflation - an increase in the expected rate of inflations lowers the expected real return for bonds, causing the demand curve to shift to the left Risk - an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity - increased liquidity of bonds results in the demand curve shifting right © 2008 Pearson Education Canada

Shifts in the Demand for Bonds (Cont’d) © 2008 Pearson Education Canada

Shifts in the Supply of Bonds Expected profitability of investment opportunities - in an expansion, the supply curve shifts to the right Expected inflation - an increase in expected inflation shifts the supply curve for bonds to the right Government activities - increased budget deficits/surpluses shift the supply curve to the right/left © 2008 Pearson Education Canada

Shifts in the Supply of Bonds (Cont’d) © 2008 Pearson Education Canada

Putting the Supply and Demand Curves together, we can apply…. (Example 1)When the government increases its expenditures and budget deficits, it has to issue more government bonds. Then…. © 2008 Pearson Education Canada

a Business Cycle Expansion Example 2) Response to a Business Cycle Expansion © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Actually, we observe that Business Cycles and Interest Rates are moving together: © 2008 Pearson Education Canada

Example 3)Response to a Lower Savings Rate © 2008 Pearson Education Canada

2. The Liquidity Preference Model © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Real Money Supply Real Money Demand = Liquidity Preference © 2008 Pearson Education Canada

Money Demand and Supply determines the equilibrium interest rate © 2008 Pearson Education Canada

Shifts in the Demand for Money Income Effect - a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right Price-Level Effect - a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right Other Monetary Demand Shocks © 2008 Pearson Education Canada

Shifts in the Supply of Money Assume that the supply of money is controlled by the central bank. An increase in the money supply engineered by the Bank of Canada will shift the supply curve for money to the right – ‘Expansionary Monetary Policy’ through OMO © 2008 Pearson Education Canada

Shifts in the Demand and Supply of Money © 2008 Pearson Education Canada

Shifts in the Demand and Supply of Money (Cont’d) © 2008 Pearson Education Canada

Shifts in the Demand and Supply of Money (Cont’d) © 2008 Pearson Education Canada

3. Inflation and Interest Rates i = r + risk premium Suppose that the only risk is inflation risk = r + inflation risk = r + expected inflation rate = r + πe © 2008 Pearson Education Canada

© 2008 Pearson Education Canada πe is the rate of expected inflation between now and one year today. What determines πe? It is the expected rate of money creation by the monetary authority: If people expect the monetary authority to increase money supply, they also expect the rate of inflation to go UP. Ultimately, πe = (ms)e © 2008 Pearson Education Canada

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? © 2008 Pearson Education Canada

Money Growth and Interest Rates © 2008 Pearson Education Canada

© 2008 Pearson Education Canada In the short-run, an increase in Money Supply leads to a fall in interest rate; In the long-run, an increase in Money Supply leads to a rise in the expected rate of inflation and, through Fisher equation, a rise in (nominal) interest rate. © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Summary 3 Models for Interest Rate Determination 1. Supply and Demand for Bonds 2. In the short-run, Money Supply and Demand - More Money Supply means a lower interest rate In the long-run, Fisher Equation -More Money means a higher rate of expect inflation and thus a higher interest rate. © 2008 Pearson Education Canada