1. Chapter 5 The Behavior of Interest Rates
Money and Banking
Chapter 5
The Behavior of Interest Rates

2. Learning Objectives
Identify the factors that affect the demand for assets.
Draw the demand and supply curves for the bond market, identify the equilibrium interest rate, and describe the factors that affect the equilibrium.
Describe the connection between the bond market and the money market through the liquidity preference framework.
List and describe the factors that affect the money market and the equilibrium interest rate.
Identify and illustrate the effects on the interest rate of changes in money growth over time.

3. Determinants of Asset Demand
Wealth: the total resources owned by the individual, including all assets
More wealth corresponds to higher demand for interest bearing assets
Positive relationship between wealth and asset demand
Expected Return: the return expected over the next period on one asset relative to alternative assets
Higher expected returns correspond to higher demand for interest bearing assets
Positive relationship between expected returns and asset demand

4. Determinants of Asset Demand
Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets
Higher risk of return for an interest bearing asset is associated with lower demand for it.
Negative relationship between risk and asset demand
Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets
The more liquid the asset, the higher the demand for it.
Positive relationship between liquidity and asset demand

5. Value of Money, Prices and Interest Rates
The value of money – how many goods and services you can buy with each dollar in your pocket
At higher prices – value of money is low
Need more dollars to buy the same quantity of goods
At lower prices - value of money is high
Need less dollars to buy the same quantity of goods
Inverse relationship between price level and value of money

6. Value of Money, Prices and Interest Rates
Interest rates represent the value of money
At higher prices – value of money is low
Need more dollars to buy the same quantity of goods
Less wealth exists in interest bearing form
Interest rates are low
At lower prices - value of money is high
Need less dollars to buy the same quantity of goods
More wealth exists in interest bearing form
Interest rates are high

7. Supply and Demand in Bond Market
Bonds represent interest bearing assets
Supply of bonds: depends on how many firms want to issue new debt to finance their investments
High interest rates (Low P): supply of bonds is low
Low interest rates (High P): supply of bonds is high
Demand for bonds: depends on how many people want to place their wealth in interest bearing form
High interest rates (Low P): demand for bonds is high
Low interest rates (High P): demand for bonds is low

8. Supply and Demand in Bond Market
Price of Bonds (P: $)
Supply of Bonds
Market Equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price
P* = 850
(i=17.6%)
Demand for Bonds
Quantity of Bonds
($ billion)

9. Supply and Demand in Bond Market
Price of Bonds (P: $)
Supply of Bonds
950 (i = 5.3%)
A(d)
A(s)
With excess supply, the bond price falls to P *
P* = 850
(i=17.6%)
When Bd < Bs , there is excess supply, price will fall and interest rate will rise
Demand for Bonds
Quantity of Bonds
($ billion)

10. Supply and Demand in Bond Market
Price of Bonds (P: $)
Supply of Bonds
When Bd > Bs , there is excess demand, price will rise and interest rate will fall
P* = 850
(i=17.6%)
A(s)
A(d)
With excess demand, the bond price rises to P *
750 (i = 33.0%)
Demand for Bonds
Quantity of Bonds
($ billion)

11. Shifts in Demand for Bonds
Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right
Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left
Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left
Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left
Liquidity: increased liquidity of bonds results in the demand curve shifting right

12. Application Question
Consider the bond market that we have just reviewed where the quantity of bonds is $240 billion, the price level is 400 and the interest rate is 10%
Draw the supply and demand model, labeling the equilibrium point
What happens in this market if people suddenly expect prices to rise rapidly in the near future? Illustrate this effect on your model and explain in words.

13. Shift in the Supply of Bonds
Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right
Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right
Government budget: increased budget deficits shift the supply curve to the right

14. Application Question
Consider the bond market from the previous application.
Draw the supply and demand model, labeling the original equilibrium point as well as the new equilibrium point after the shift in demand.
What happens in this market if people suddenly expect prices to rise rapidly in the near future? Illustrate this effect on your model and explain in words.

15. Response to a Change in Expected Inflation
Price of Bonds, P
Step 1. A rise in expected inflation shifts the bond demand curve leftward . . .
Step 2. and shifts the bond supply curve rightward . . . 1 P1
Step 3. causing the price of bonds to fall and the equilibrium interest rate to rise. 2 P2
Quantity of Bonds, B

16. Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2014

17. Application Question
Consider a bond market where the quantity of bonds is $750 billion, the price level is 200 and the interest rate is 7%
Consider the impact of a business cycle expansion: (1) firms are optimistic about the future – they are investing in their production capabilities, (2) as economic activity expands, so does wealth for most people.
What impact will that have on the bond market? Illustrate this effect on your model and explain in words.

18. Response to a Business Cycle Expansion
Price of Bonds, P
Step 1. A business cycle expansion
shifts the bond supply curve
rightward . . .
Step 2. and shifts the bond demand
curve rightward, but by a lesser
amount . . . P1 1 2 P2
Step 3. so the price of bonds falls
and the equilibrium interest rate
rises.
Quantity of Bonds, B

19. Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2014

20. Application Question
Consider a bond market where the quantity of bonds is $500 billion, the price level is 250 and the interest rate is 2.5%
Consider the current administration’s commitment to cutting the budget deficit in the United States. If it is successful, what impact will that have on the bond market? Illustrate this effect on your model and explain in words.

21. Market for Money: Liquidity Preference Framework
People store their wealth in two main forms:
Money or Bonds
Total wealth in the economy: Ms + Bs = Md + Bd
Md – Ms = Bs – Bd
If the money market is in equilibrium (Ms = Md)
So is the bond market (Bs = Bd)

22. Market for Money Prices adjust to bring MD = MS
high
low
Prices adjust to bring
MD = MS
People will adjust how much money they must hold in response to price change
i.1
P.1
P.2 MD
low
high
Qm.1
Quantity of Money

23. SURPLUS: INTEREST RATES FALL; PRICE LEVEL RISES
Market for Money MS i P
high
low
Prices adjust to bring
MD = MS
People will adjust how much money they must hold in response to price change
SURPLUS: INTEREST RATES FALL; PRICE LEVEL RISES
Md < Ms
SURPLUS OF MONEY
People want to hold less cash than is available
Prices Rise
Interest Rates fall
i.1
P.1
P.2 MD
low
high
Qm.1
Quantity of Money

24. SHORTAGE: INTEREST RATES RISE; PRICE LEVEL FALLS
Market for Money MS i P
high
low
Prices adjust to bring
MD = MS
People will adjust how much money they must hold in response to price change
SHORTAGE: INTEREST RATES RISE; PRICE LEVEL FALLS
Md > Ms
SHORTAGE OF MONEY
People want to hold more cash than is available
Prices fall
Interest Rates Rise
i.1
P.1
P.2 MD
low
high
Qm.1
Quantity of Money

25. Market for Money MS i P high low i.1 P.2 MD high low Qm.1
Quantity of Money

26. Market for Money Demand for money: Shifts in the demand for money:
As the interest rate increases:
The opportunity cost of holding money increases…
The relative expected return of money decreases…
…and therefore the quantity demanded of money decreases.
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

27. Market for Money 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.

28. Application Question Consider the market for money
Draw the Ms-Md diagram, labeling the equilibrium point
Now consider the impact of a sudden increase in wealth in the economy, causing people to demand more money at each interest rate.
What is the effect on the market for money? Illustrate and explain your answer.

29. Response to a Change in Income or the Price Level
Interest Rate, i Ms
Step 1. A rise in income or the price level shifts the money demand curve rightward . . . i2 2
Step 2. and the equilibrium interest rate rises. i1 1
Quantity of Money, M

30. Application Question
Suppose the Fed decides to increase the money supply through open market operations. It decides to buy bonds from the public.
What happens to the new equilibrium price level, value of money and equilibrium quantity of money?
In the interim (before price level adjusts), is there a surplus or shortage of money?

31. Changes in Money SupplyMS
MS.2 i P
high
low
i.1
P.2 MD
low
high
Qm.1
Qm.2
Quantity of Money

32. Changes in Money SupplyMS
MS.2 i P
high
low
MD < MS
SURPLUS
i.1
P.2 MD
low
high
Qm.1
Qm.2
Quantity of Money

33. Changes in Money SupplyMS
MS.2 i P
high
low
SURPLUS
i.1
P.2 B
i.2 MD
low
high
Qm.1
Qm.2
Quantity of Money

34. Coping with Surplus of Money
When there is a surplus of money, people try to get rid of it:
Using the surplus to purchase goods and services  more demand  price of goods increases
Putting money in the loanable funds market  more loans available  Increase in demand for goods
↑MS = ↑ savings= ↓ interest rates

35. Coping with Surplus of Money
When there is a surplus of money, people try to get rid of it:
Using the surplus to purchase goods and services  more demand  price of goods increases
Buy bonds from people  Bd decreases  decrease interest rates
↑MS = ↓ Bd= ↓ interest rates
↑MS = ↑ demand for goods= ↑ price level