THE BEHAVIOR OF INTEREST RATES Chapter 5 – EC311 Susanto THE BEHAVIOR OF INTEREST RATES

Determinants of Asset Demand An asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 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 If returns on two assets are equal, risk-averse people will prefer the lower-risk asset. 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets. An asset is liquid if the market in which it is traded has depth and breadth (many sellers and buyers). © 2004 Pearson Addison-Wesley. All rights reserved

EXAMPLE 1: Expected Return What is the expected return on an Exxon-Mobil bond if the return is 12% two-thirds of the time and 8% one-third of the time? Solution The expected return is 10.68%. Re = p1R1 + p2R2 where p1 = probability of occurrence of return 1 = 2/3 = .67 R1 = return in state 1 = 12% = 0.12 p2 = probability of occurrence return 2 = 1/3 = .33 R2 = return in state 2 = 8% = 0.08 Thus Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68% Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Determinants of Asset Demand Wealth: Increase in wealth  increased demand for ‘normal’ assets. Expected return: Higher RETe on a particular asset  increased demand for that asset  decreased demand for other (alternative) assets. Risk: Increase in an asset's risk (relative to other assets)  decreased demand for that asset  increased demand for other assets Liquidity: Increase in an asset's liquidity (relative to other assets)  decreased demand for other assets © 2004 Pearson Addison-Wesley. All rights reserved

Determinants of Asset Demand © 2004 Pearson Addison-Wesley. All rights reserved

Demand and Supply of Bonds Recall that, all else equal: PBOND ↓ if i ↑ That is, for any particular type of bond, the market market price P is inversely related to the market interest rate (yield to maturity) on this type of bond. Why?? © 2004 Pearson Addison-Wesley. All rights reserved

The Demand Curve Let’s start with the demand curve. Let’s consider a one-year discount bond with a face value of $1,000. In this case, the return on this bond is entirely determined by its price. The return is, then, the bond’s yield to maturity. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Derivation of Demand Curve Point A: if the bond was selling for $950. Point B: if the bond was selling for $900. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Derivation of Demand Curve How do we know the demand (Bd) at point A is 100 and at point B is 200? Well, we are just making-up those numbers. But we are applying basic economics – more people will want (demand) the bonds if the expected return is higher. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Derivation of Demand Curve To continue … 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

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 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Supply and Demand Analysis of the Bond Market 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* © 2004 Pearson Addison-Wesley. All rights reserved

Market Conditions 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 Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Loanable Funds Terminology 1. Demand for bonds = supply of loanable funds 2. Supply of bonds = demand for loanable funds © 2004 Pearson Addison-Wesley. All rights reserved

Changes in Equilibrium Interest Rates We now turn our attention to changes in interest rate. We focus on actual shifts in the curves. Remember: movements along the curve will be due to price changes alone. The shifting of the entire demand or supply curve are is caused by a factor (or a combination of factors) other than price. First, we examine shifts in the demand for bonds. Then we will turn to the supply side. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Shifts in the Bond Demand Curve © 2004 Pearson Addison-Wesley. All rights reserved

Factors that Shift the Bond Demand Curve 1. Wealth A. Economy grows, wealth , Bd , Bd shifts out to right 2. Expected Return A. i  in future, Re for long-term bonds , Bd shifts out to right B. e , Relative Re , Bd shifts out to right C. Expected return of other assests , Bd , Bd shifts to left 3. Risk A. Risk of bonds , Bd , Bd shifts out to right B. Risk of other assets , Bd , Bd shifts out to right 4. Liquidity A. Liquidity of Bonds , Bd , Bd shifts out to right B. Liquidity of other assets , Bd , Bd shifts out to right © 2004 Pearson Addison-Wesley. All rights reserved

Shifts in the Demand for Bonds Wealth: In a business cycle expansion with growing wealth, the demand for bonds rises; in a recession, when income and wealth are falling, the demand for bonds falls. 2. Expected returns: higher expected interest rates in the future decrease the demand for long-term bonds; lower expected interest rates in the future increase the demand for long-term bonds. 3. Risk: as a bond’s riskiness increases, the demand for bonds to fall; if the riskiness of alternative assets (like stocks) increases (relative to bonds), the demand for bonds to rise. 4. Liquidity: increased liquidity of the bond market results in an increased demand for bonds; increased liquidity of alternative asset markets lowers the demand for bonds. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Factors that Shift Demand Curve for Bonds © 2004 Pearson Addison-Wesley. All rights reserved

Shifts in the Bond Supply Curve 1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , Bs , Bs shifts out to right 2. Expected Inflation e , Bs , Bs shifts out to right 3. Government Activities Deficits , Bs , Bs shifts out to right

Factors that Shift Supply Curve for Bonds © 2004 Pearson Addison-Wesley. All rights reserved

Shifts in the Supply Curve 1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , Bs , Bs shifts out to right. Expected Inflation πe , Bs , Bs shifts out to right 3. Government Activities Deficits , Bs , Bs shifts out to right Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Shifts in the Supply of Bonds Expected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls Expected Inflation: an increase in expected inflation causes the supply of bonds to increase Government Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Changes in πe: The Fisher Effect If πe  Relative Re , Bd shifts in to left Bs , Bs shifts out to right P , i  Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of the Fisher Effect If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls. The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase. When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls. Since the bond price is negatively related to the interest rate, this means that the interest rate will rise. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Evidence on the Fisher Effect in the United States Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Business Cycle Expansion Wealth , Bd , Bd shifts out to right Investment , Bs , Bs shifts right If Bs shifts more than Bd then P , i  Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Evidence on Business Cycles and Interest Rates Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two Categories of Assets in Wealth: Money and 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 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 © 2004 Pearson Addison-Wesley. All rights reserved

Liquidity Preference Analysis Derivation of Demand Curve 1. Keynes assumed money has i = 0 2. As i , relative RETe on money  (equivalently, opportunity cost of money )  Md  3. Demand curve for money has usual downward slope Derivation of Supply curve 1. Assume that central bank controls Ms and it is a fixed amount 2. Ms curve is vertical line Market Equilibrium 1. 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% © 2004 Pearson Addison-Wesley. All rights reserved

Money Market Equilibrium © 2004 Pearson Addison-Wesley. All rights reserved

Rise in Income or the Price Level 1. Income , Md , Md shifts out to right 2. Ms unchanged 3. i* rises from i1 to i2 © 2004 Pearson Addison-Wesley. All rights reserved

Rise in Money Supply 1. Ms , Ms shifts out to right 2. Md unchanged 3. i* falls from i1 to i2 © 2004 Pearson Addison-Wesley. All rights reserved

Money and Interest Rates Effects of money on interest rates 1. Liquidity Effect Ms , Ms shifts right, i  2. Income Effect Ms , Income , Md , Md shifts right, i  3. Price Level Effect (Liquidity framework) Ms , Price level , Md , Md shifts right, i  4. Expected Inflation Effect (Loanable funds framework) Ms , e , Bd , Bs , Fisher effect, i  Effect of higher rate of money growth on interest rates is ambiguous 1. Because income, price level and expected inflation effects work in opposite direction of liquidity effect © 2004 Pearson Addison-Wesley. All rights reserved

Does Higher Money Growth Lower Interest Rates?