The Behavior of Interest Rates Chapter Four The Behavior of Interest Rates

Determinants of Asset Demand

Benefits of Diversification Diversification almost always beneficial to risk-averse investor Less returns of securities move together, greater is risk reduction from diversification

Derivation of Demand Curve Point A Point B

Derivation of Demand Curve 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

Supply and Demand Analysis of the Bond Market Figure 4-1: Supply and Demand for Bonds

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

Market Equilibrium Occurs when Bd = Bs, at P* = 850, i* = 17.6% When P = $950, i = 5.3%, Bs > Bd (excess supply): P  to P*, i  to i* When P = $750, i = 33.0, Bd > Bs (excess demand): P  to P*, i  to i*

Loanable Funds Terminology Demand for bonds = supply of loanable funds Supply of bonds = demand for loanable funds Figure 4-2: A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

Shifts in the Demand Curve Figure 4-3: Shifts in the Demand Curve for Bonds

How Factors Shift the Demand Curve Wealth Economy , wealth , Bd , Bd shifts out to right Expected Return i  in future, Re for long-term bonds , Bd shifts out to right πe , relative Re , Bd shifts out to right Risk Risk of bonds , Bd , Bd shifts out to right Risk of other assets , Bd , Bd shifts out to right Liquidity Liquidity of bonds , Bd , Bd shifts out to right Liquidity of other assets , Bd ,Bd shifts out to right

Factors That Shift Demand Curve

Shifts in the Supply Curve Profitability of Investment Opportunities Business cycle expansion, investment opportunities , Bs , Bs shifts out to right Expected Inflation πe , Bs , Bs shifts out to right Government Activities Deficits , Bs , Bs shifts out to right Figure 4-4: Shift in the Supply Curve for Bonds

Factors That Shift Supply Curve

Changes in πe: The Fisher Effect If πe  Relative Re , Bd shifts in to left Bs , Bs shifts out to right P , i  Figure 4-5: Response to a Change in Expected Inflation

Evidence on the Fisher Effect in the United States Figure 4-6: Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2001

Business Cycle Expansion Wealth , Bd , Bd shifts out to right Investment , Bs , Bs shifts right If Bs shifts more than Bd then P , i  Figure 4-7: Response to a Business Cycle Expansion

Evidence on Business Cycles and Interest Rates Figure 4-8: Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2001

Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two categories of assets in wealth money bonds Thus: Ms + Bs = Wealth Budget constraint: Bd + Md = Wealth Therefore: Ms + Bs = Bd + Md Subtracting Md and Bs from both sides: Ms  Md = Bd  Bs

Relation of Liquidity Preference Framework to Loanable Funds Money Market Equilibrium Occurs when Md = Ms Then Md  Ms = 0 which implies that Bd  Bs = 0, so that Bd = Bs and bond market is also in equilibrium

Relation of Liquidity Preference Framework to Loanable Funds Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money in liquidity preference framework Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects from changes in expected returns on real assets

Liquidity Preference Analysis Derivation of Demand Curve Keynes assumed money has i = 0 As i , relative Re on money  (equivalently, opportunity cost of money )  Md  Demand curve for money has usual downward slope Derivation of Supply curve Assume that central bank controls Ms and is a fixed amount Ms curve is vertical line

Liquidity Preference Analysis Market Equilibrium Occurs when Md = Ms, at i* = 15% If i = 25%, Ms > Md (excess supply): Price of bonds , i  to i* = 15% If i =5%, Md > Ms (excess demand): Price of bonds , i  to i* = 15%

Money Market Equilibrium Figure 4-10: Equilibrium in the Market for Money

Rise in Income Income , Md , Md shifts out to right Ms unchanged i* rises from i1 to i2 Figure 4-11: Response to a Change in Income

Rise in Price Level Price level , Md , Md shifts to right Ms unchanged i* rises from i1 to i2 Figure 4-12: Response to a Change in Price Level Current inflation statistics ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Rise in Money Supply Ms , Ms shifts out to right Md unchanged i* falls from i1 to i2 Figure 4-13: Response to a Change in the Money Supply Current money supply figures http://www.federalreserve.gov/releases/h6/current

Money and Interest Rates Effects of money on interest rates Liquidity Effect Ms , Ms shifts right, i  Income Effect Ms , Income , Md , Md shifts right, i  Price Level Effect Ms , Price level , Md , Md shifts right, i  Expected Inflation Effect Ms , πe , Bd , Bs , Fisher effect, i 

Money and Interest Rates Effect of higher rate of money growth on interest rates is ambiguous Because income, price level and expected inflation effects work in opposite direction of liquidity effect

Does Higher Money Growth Lower Interest Rates? Figure 4-14: Response over Time to an Increase in Money Supply Growth

Evidence on Money Growth and Interest Rates Figure 4-15: Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2001

Profiting from Interest-Rate Forecasts Methods for forecasting Loanable funds: use Flow of Funds Accounts and judgment Econometric Models: large in scale, use liquidity preference Make decisions about assets to hold Forecast i , buy long bonds Forecast i , buy short bonds Make decisions about how to borrow Forecast i , borrow short Forecast i , borrow long

Supply and Demand in Gold Market Deriving Demand Curve Pet+1 is held constant Pt , ge , Re   Gd  Demand curve is downward sloping Deriving Supply Curve Pt , more production, Gs  Supply curve is upward sloping

Supply and Demand in Gold Market Market Equilibrium Gd = Gs If Pt > P* = P1, Gs > Gd, Pt  to P* If Pt < P* = P1, Gs < Gd, Pt  to P*

Changes in Equilibrium Factors That Shift Demand Curve for Gold Wealth Expected return on gold relative to alternative assets Riskiness of gold relative to alternative assets Liquidity of gold relative to alternative assets Factors That Shift Supply Curve for Gold Technology of mining Government sales of gold

Response of Gold Market to a Change in πe If πe  πe , Pet+1 ; at given Pt, ge   Gd   Gd shifts right Go to point 2; Pt  Price of gold positively related to πe Gold price is barometer of π- pressure Figure 4-A1: A Change in the Equilibrium Price of Gold