Chapter 6: Learning Objectives Interest Rate Level Determination:
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference Equilibrium Determination & Changes
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference Equilibrium Determination & Changes Applications:
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference Equilibrium Determination & Changes Applications: Fisher effect
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference Equilibrium Determination & Changes Applications: Fisher effect interest rates over the business cycle
Chapter 6: Learning Objectives Interest Rate Level Determination: Loanable funds vs. Liquidity preference Equilibrium Determination & Changes Applications: Fisher effect interest rates over the business cycle the impact of a tight monetary policy
A Selection of Yields over Time
Loanable Funds Theory Focus is on the Market for bonds
Loanable Funds Theory Focus is on the Market for bonds Bond demand (B d ) is determined by investors’ preferences
Loanable Funds Theory Focus is on the Market for bonds Bond demand (B d ) is determined by investors’ preferences Bond supply (B s ) is determined by borrowers’ preferences
Loanable Funds Theory Focus is on the Market for bonds Bond demand (B d ) is determined by investors’ preferences Bond supply (B s ) is determined by borrowers’ preferences For discussion purposes, ASSUME a one-year discount bond $PD is inversely related to R (=[$FV-$PD]/$PD
Loanable Funds Theory Focus is on the Market for bonds Bond demand (B d ) is determined by investors’ preferences Bond supply (B s ) is determined by borrowers’ preferences For discussion purposes, ASSUME a one-year discount bond $PD is inversely related to R (=[$FV-$PD]/$PD) The interaction between Bond demand and supply determines the equilibrium interest rate
BOND DEMAND=SUPPLY OF LOANABLE FUNDS From Bond demand/supply to Loanable funds demand/supply
BOND DEMAND=SUPPLY OF LOANABLE FUNDS BOND SUPPLY=DEMAND FOR LOANABLE FUNDS
Figure 6.4. Market Equilibrium E Quantity of bonds Nominal interest rate Excess supply Excess demand LF s LF d B* R* AB R0R0 CD R1R1
Shifts in Loanable Funds demand/supply DEMAND SIDE INFLUENCES Wealth (+ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply Expected returns (+ve) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply Expected returns (+ve) Govt policies (?) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES
Shifts in Loanable Funds demand/supply Expected returns (+ve) Govt policies (?) Expected Inflation (+ve) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES
Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds A. A Demand Shift B LF d 2 R2R2 B2B2 Quantity of bonds Nominal interest rate B1B1 R1R1 A LF d 1
Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds B. A Supply Shift B2B2 LF s 2 Quantity of bonds Nominal interest rate R1R1 B1B1 LF s 1
Two Applications Figure 6.6 The Fisher Effect: how inflation expectations affect nominal interest rates distinction between nominal and real interest rates (Recall: R= + e ) Figure 6.6
Two Applications Figure 6.6 The Fisher Effect: how inflation expectations affect nominal interest rates distinction between nominal and real interest rates (Recall: R= + e ) Figure 6.6 Figure 6.8 The business cycle and interest rates: how changes in economic activity affect nominal interest rates Figure 6.8
Figure 6.6. The Fisher Effect B* Quantity of bonds Nominal interest rate LF s 0 LF d 0 R* 0 = * 0 + e 0 E LF d 1 LF s 1 R* 1 = * 0 + 1 e E’
Figure 6.8. Interest Rates in an Expansion LF d 1 B1B1 E’ LF s 1 R* 1 LF d 0 Quantity of bonds Nominal interest rate B0B0 R* 0 E LF s 0
The Nominal Interest Rate and Economic Growth
Economics Focus 6.2: Measuring Real GDP Product Expendit ure Base year Quantitie s consume d Base year Price Base year Expendit ure Current year Quantitie s consume d Current year Price Current year Haircut $30030$10$40020$20 Watches $20010$20$50020$25 GDP$500$900
Economics Focus 6.2: Measuring Real GDP [Cont’d] Fixed-Weight method (Base year prices) Fixed-weight (Current year prices) [20*$10+20*$20]/$50 0 = 1.2 GDP rises by 20% $900/[30*$20+10*$25 ] = $900/$850= 1.06 GDP rises by 6% Averaging the two yields: SQRT(1.20*1.06)= 1.13 GDP rises by 13%
Liquidity Preference Theory Focus is on the role of monetary policy
Liquidity Preference Theory Focus is on the role of monetary policy Demand for money (M d ) is determined by the preferences of holders of money ( M1)
Liquidity Preference Theory Focus is on the role of monetary policy Demand for money (M d ) is determined by the preferences of holders of money ( M1) Supply of Money is determined by the central bank and the financial sector
Liquidity Preference Theory Focus is on the role of monetary policy Demand for money (M d ) is determined by the preferences of holders of money ( M1) Supply of Money is determined by the central bank and the financial sector The interaction of money demand/supply produces an equilibrium interest rate
Why Hold Money? TRANSACTIONS MOTIVE: used in the buying and selling of goods and services
Why Hold Money? TRANSACTIONS MOTIVE: used in the buying and selling of goods and services PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events
Why Hold Money? TRANSACTIONS MOTIVE: used in the buying and selling of goods and services PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events SPECULATIVE MOTIVE: represents one asset in a “portfolio” of assets
Analysis of Monetary Policy Money Supply Time Money Supply Time Ms1Ms1 MS0MS0 g=0 g><0 g=0 Static AnalysisDynamic Analysis = {[M S t - M S t-1 ]/M S t-1 } X 100
Figure Contractionary Monetary Policy Quantity of money Nominal interest rate Ms0Ms0 Md0Md0 E R* 0 M* 0 Ms1Ms1 R* 1 M* 1
Money Growth and Interest Rates
The (Dynamic) Link Between Money Growth and the Interest Rate Time 00 11 22 R R0 R1 R2 Time
The Liquidity Trap When nominal interest rates are close to zero can monetary policy be effective
The Liquidity Trap When nominal interest rates are close to zero can monetary policy be effective? It has been suggested that monetary policy is then like pushing on a string
The Liquidity Trap When nominal interest rates are close to zero can monetary policy be effective? It has been suggested that monetary policy is then like pushing on a string But, monetary policy is more than just changing the money supply or even changing interest rates. Its about changing expectations of future inflation. The trap can, in principle, be avoided
Summary There are 2 theories of interest rate determination: the loanable funds and liquidity preference models
Summary There are 2 theories of interest rate determination: the loanable funds and liquidity preference models Loanable funds focuses on the bond market
Summary There are 2 theories of interest rate determination: the loanable funds and liquidity preference models Loanable funds focuses on the bond market Liquidity preference focuses on the demand for money and the role of monetary policy
Summary There are 2 theories of interest rate determination: the loanable funds and liquidity preference models Loanable funds focuses on the bond market Liquidity preference focuses on the demand for money and the role of monetary policy Equilibrium interest rates change because of changes in liquidity, risk, expectations, govt and central bank policies