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

 Bond Price will  interest rate Monetary policy:  GDP Fed buys bonds - price rises - interest rates fall - spending rises -  GDP  Inflation 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. Demandinvestment Demand = investment. negatively sloped - why? Supplysavingnet K flows Supply = saving + net K flows K inflow - foreigners saving here. K outflow - we are saving abroad. positively sloped - why?

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. Shifts in demand will change equilibrium r. For example... Shifts in supply will change equilibrium r. Shifts in supply will change equilibrium r. For example...

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

The “Market” for Money

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

Dealing with Risk Risk is an example of asymmetric information, where bond rating services are the market solution for this problem.

Case: GM Bond Rating

Quick Hits Fisher equation: i = r +  e Market for LF determines r. “r” is ex ante – before the fact.  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

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 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. Bond $1000 $50 Perpetuity

Unanticipated Inflation Premium Assume that the current market (nominal) rate of interest for these instruments is 5% and that the inflation rate ( π ) is 2%. We can easily calculate the price of each financial instrument: Bond $1000 $50 Perpetuity 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 = $ $ The perpetuity price falls to $50/.07 = $ So, we may interpret the “normal” yield curve with respect to unanticipated inflation (  ua ). Longer terms command higher yields to account for this outcome.

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