How rates are determined The Term Structure Interest Rates II: How rates are determined The Term Structure Money & Banking - ECO 473 - Dr. D. Foster

 Bond Price will  interest rate Monetary policy: Fed buys bonds - price rises - interest rates fall - spending rises -  GDP Fed sells bonds - price falls - interest rates rise - spending falls -  Inflation

The Loanable Funds Theory Real interest rates (r) are determined by the supply and demand for loans. Demand = investment. negatively sloped - why? Supply = saving + net K flows K inflow - foreigners saving here. K outflow - we are saving abroad. positively sloped - why? 3

The Market for Loanable Funds 4

The Market for Loanable Funds The market generates an equilibrium expected (ante) real interest rate. Why is equilibrium stable? Shifts in demand will change equilibrium r. For example . . . Shifts in supply will change equilibrium r. 5

The Liquidity Preference Theory The nominal interest rate (i) is determined by the supply and demand for money. Money supply = MS and is determined by the Federal Reserve. Money demand = MD and is used for exchange purposes. But, i=opportunity cost of holding money. Consumers weigh benefits & costs. Negatively sloped. Why? 6

The “Market” for Money 7

Why do Interest Rates differ? Default risk (Il)liquidity risk “Risk premium” = i - iT-Bill where the T-Bill is the riskless rate. How do you distinguish default from liquidity risk?

Quick Hits Fisher equation: i = r + e Irving Fisher Fisher equation: i = r + e Market for LF determines r. “r” is ex ante – before the fact (re). e can be based on adaptive/rational expectations. Adjusting for risk premiums, i still differs … by maturities; aka “term structure of interest rates.” a positive “term premium”  normal yield curve. a negative “term premium”  inverted yield curve.

Term Structure of Interest Rates Click to follow link.

Causes of the term structure Segmented markets Different terms are not good substitutes. Expectations If we expect r to rise, longer-term bonds will earn a higher interest rate. Preferred habitat Longer terms require a premium . . . usually. [Unanticipated] Inflation premium (ua). . .

Unanticipated Inflation Premium Consider a 1 yr. bond and a perpetuity Bond $1000 $50 Perpetuity The bond has a face value of $1000 and has a $50 coupon. In one year the bond holder will be able to redeem the total, $1050. The perpetuity redeems $50 per year forever.

Unanticipated Inflation Premium $1000 $50 $50 Bond Perpetuity Assume that the current market (nominal) rate of interest for these instruments is 5%, of which 2% is for expected inflation (πe). We can easily calculate the price of each financial instrument: Bond price = $1050/1.05 = $1000 Perpetuity price = $50/.05 = $1000

Unanticipated Inflation Premium What happens to prices if actual inflation, , (say tomorrow) rises to 4%? The bond price will fall to $1050/1.07 = $981.30 The perpetuity price falls to $50/.07 = $714.30 So, we may interpret the “normal” yield curve with respect to unanticipated inflation (ua): Longer terms command higher yields to account for this asymmetric risk.

What if Inflation is Correctly Anticipated? As with expected interest rate changes, no reason to favor one outcome here. The yield curve will reflect that: Maturity Yield Expect rising inflation Expect falling inflation Expect constant inflation

Negative Interest Rate Policy (Pardon me if I NIRP) Central Banks start charging interest on bank reserves -- A service fee? -- Purpose? Stimulate lending/spending/econ. activity Will the Federal Reserve follow suit? -- They have been paying interest on reserves! -- They want to raise interest rates! -- Their policy is rooted in fear of spending! Will bank depositors be next? -- This will lead to Deposits and Cash! -- This will raise transaction costs! -- The next step – prohibit cash!

How rates are determined The Term Structure Interest Rates II: How rates are determined The Term Structure Money & Banking - ECO 473 - Dr. D. Foster