1 The determination of bond prices and interest rates Mishkin, Chap 5

2 Chap 5 discusses: I.The classical theory of bond prices and interest rates II.The liquidity preference theory (Keynesian theory) of bond prices and interest rates III.Critique of the liquidity preference theory - Money supply and the market interest rates

3 Difference between a market for loans and a bond market – a recap In a market for loans, the interest rate on a loan is determined by market forces of demand and supply. Given a LV and n, the FP is then determined from the PV relationship. Equivalently, given FP and n, the LV is then determined from the PV relationship. In a market for bonds, the bond price is determined by market forces or demand and supply. Given C, FV and n, the interest rate or yield to maturity is then determined from the PV relationship. Thus the difference lies in which is regarded as the market determined variable – price or interest rate.

4 I.The classical theory of bond prices and interest rates Demand for a bond (generally for any asset) depends on: average time preference of households; the more willing the households are to defer their current consumption, the _________ the demand. average wealth level of households ; the higher the wealth level, the _______ the demand expected return on the bond over the holding period; the greater the expected return the ________ the demand the risk on the bond; assuming agents to be risk averse, the greater the risk, the ________ the demand. Risk is often measured by _______ the liquidity of the bond; the greater the liquidity the _______ the demand. Liquidity is often measured by ________

5 Demand for bonds Given wealth, savings propensities, risk and liquidity, quantity demanded of bond is _________ related to the expected return on it. If so, how is the quantity demanded related to the current market price of the bond? Hint: Back to chap 4 for short term investors: one period RET = (C + P t+1 – P t )/P t for someone who holds till maturity: RET = YTM based on the current market price How is RET related to P t in both cases? Hence quantity demanded is _______ related to current market price. The demand curve for bonds shows

6 Supply of bonds From the issuer’s (borrower’s) point of view, what is the cost of borrowing? Hence, quantity supplied of bonds is _______ related to its current market price everything else constant. The supply curve of a bond shows Equilibrium in the bond market: the price at which quantity demanded ________ quantity supplied. If bond price > market clearing price If bond price < market clearing price Equilibrium price implies a corresponding equilibrium interest rate. Why?

7 price of the bond quantity of the bond 1.Draw the demand and supply of the bond. Indicate the sources of each (who demands or supplies?) 2.Add a third interest rate axis to alternatively express these relationships.

8 The market for loanable funds is another name for the market for bonds. Demand for bonds = __________ loanable funds; Supply of bonds = __________ loanable funds; Interest rate Quantity of bonds Draw the supply of and demand for loanable funds and also mark them with their alternative labels.

9 Factors affecting demand, supply and the equilibrium interest rate 1.increase in the average wealth level? 2. increase in expected (future) interest rate? Price of the bond Quantity of the bond D0D0 Price of the bond Quantity of the bond D0D0 Hint: What happens to the future price of the bond? What happens to the one period rate of return? S0S0 S0S0

10 3. increase in the expected return on an alternative asset such as a stock or another bond? 4. increase in the riskiness of the bond; effect on an alternative asset Price of the bond Quantity of the bond D0D0 P Q D0D0 S0S0 S0S0

11 5. increase in the liquidity of the bond? effect on an alternative asset 6. Increase in the expected (future) inflation rate, assuming this is a nominal bond? P Q D0D0 P Q S0S0 D0D0 S0S0 What happens to the equilibrium nominal interest rate?

12 7.increase in business profitability? 8. increase in the government budget deficit? P Q D0D0 S0S0 P Q D0D0 S0S0

13 Changes in  e : the Fisher Effect D0D0 Price of a bond Quantity of bond S0S0 What happens to demand and supply as π e increases? Are the shifts equal? What happens to equilibrium price? Equilibrium quantity? Equilibrium nominal interest rate?

14 Effects of Business cycles - expansion D0D0 Price of a bond Quantity of bond S0S0 What happens to demand and supply during expansions? Are the shifts equal? What happens to equilibrium price? Equilibrium quantity? Equilibrium interest rate?

15 II. Liquidity preference or Keynesian theory of the interest rate Assume only 2 types of assets, bonds and money B s + M s = B d + M d = total wealth of individuals or B s – B d = M d – M s If the money market is ___________, the bond market is ____________also. Excess ________ in the bond market implies excess _______ in the money market and the reverse. The bond market can be analyzed by analyzing the money market. (Note: method doesn’t work if there are more than 2 assets) Demand for money: money is demanded i)because of its this component depends on i)because it can act as a this component

16 Supply of money: assumed constant for the present Money market equilibrium: assuming _______ price level and income level, the __________ at which M d = M s Interest rate Quantity of money The demand for and supply of money and show the equilibrium interest rate.

17 Factors that affect demand, supply and the equilibrium interest rate, according to the liquidity preference theory: 1. an increase in income? 2. an increase in the price level? Interest rate Quantity of money i M 3. An increase in money supply? i M (3) is called the liquidity effect of an increase in money supply.

18 III. Critique of LP theory Major difference between the classical and the Keynesian (LP) theory: The Keynesian theory ignores some other effects of an increase in money supply on the interest rate. These are - Of the above three, the classical theory of interest emphasizes _____ as the most important quantitatively in the long run.