1 Lecture 10: Interest rate and liquidity preference Mishkin Ch 5 - part B page

2 Review Theory of asset demand  interest rate  bond price, negatively related  move along D&S curves vs. shift of D&S curves move along  determination: intersection of demand curve (slope downwards) and supply curve (slope upwards)  changes: shifts of demand and supply curves  changes in equilibrium price (i.e. interest rate) changes

3 Movements along D&S curves If price is $950, aggregate demand would be 100 b bonds. If price is $850, aggregate demand would be 300 b bonds.

4 Shift of D&S curves In expansion, wealth increase, for any given price, everyone demands more bonds. back

5 Shift of demand curve (money lender, bond buyer) shift right left right increase wealth expected return risk liquidity reasons expansion expected inflation decrease; expect future interest rate to be lower than previously anticipated.  e , real expected return (= nominal return – expected inflation)  Expect i  in future, P t+1 , rate of return for long-term bonds 

6 Shift of supply curve (money borrower, bond seller) shift right increase profitability of investment expected inflation deficit expected inflation  e  real interest rate (= nominal interest rate -  e )  real cost of borrowing 

7 Example: expected inflation real expected return (= nominal return – expected inflation)   D  real interest rate (= nominal interest rate -  e )   S  ‘Fisher Effect’: expected inflation   bond price   interest rate 

8  e and i move together

9 Background Liquidity preference framework proposed by John Maynard Keynes. from the perspective of ‘money’ assume there are 2 assets:  bond + money = total wealth

10 supply side:M s + B s = Wealth demand side: B d + M d = Wealth  M s + B s = B d + M d subtracting M d and B s from both sides:  M s – M d = B d – B s Conclusion: If money market is in equilibrium (money demand equals money supply: M d = M s ), then bond market is also in equilibrium (bond demand equals bond supply: B d = B s ). Bridge

11 Demand curve of money assume that money earns no interest as i , relative rate of return on money  (equivalently, opportunity cost of money  )  M d  Y-axis is now for interest rate ( not P bond ! ) demand curve (relationship between interest rate and quantity of money demand) slopes downwards

12 Supply curve of money assume that central bank controls M s and it is a fixed amount. supply curve is vertical line.

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14 Market equilibrium market equilibrium:  equilibrium quantity of money: M d = M s,  ‘price’ of money/equilibrium interest rate: i* If i > i*, M s > M d (excess supply of money! central bank supply more money than people are willing to hold!)  price of bonds , i  back to i* If i M s (excess demand)  price of bonds , i  back to i*

15 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.

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17 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 Federal Reserve will shift the supply curve for money to the right.

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19 Dose everything else remain equal? Liquidity preference framework says that an increase in the money supply will lower interest rates, if other things remain unchanged - the liquidity effect. Noble prize winner Milton Friedman argue: Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy. M s , expansionary influence on economy  national income , M d , M d shifts right, i 

20 Everything else remaining equal? Price-level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level. M s , price level , M d , M d shifts right, i  Expected-inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future. M s ,  e , B d , B s , Fisher Effect, i 

21 The million-dollar question: If money supply M s  1. liquidity effect: i  2. income effect: i  3. price-level effect: i  4. expected inflation effect: i  What’s the net effect on interest rate? Effect of higher rate of money growth on interest rates is ambiguous.

22 Money Growth & Interest Rates

23 Recap D&S curves of money and the equilibrium shifts in D&S curves effects of money growth on interest rate