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

2.  Bond Price will  interest rate
Monetary policy:
Fed buys bonds - price rises - interest rates fall - spending rises -  GDP
Fed sells bonds - price falls - interest rates rise - spending falls -  Inflation

3. The Loanable Funds Theory
Real interest rates (r) are determined by the supply and demand for loans.
Demand = investment.
negatively sloped - why?
Supply = saving + net financial flows (NF)
NF inflow - foreigners saving here.
NF outflow - we are saving abroad.
positively sloped - why? 3

4. The Market for Loanable Funds
Supply (saving + NF flows) 4

5. 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.
For example . . .
Shifts in supply will change equilibrium r. 5

6. The Liquidity Preference Theory
The nominal interest rate (i) is determined by the supply and demand for money.
Money supply = MS and is determined by the Federal Reserve.
Money demand = MD and is used for exchange purposes.
But, i=opportunity cost of holding money.
Consumers weigh benefits & costs.
Negatively sloped. Why? 6

7. The “Market” for Money 7

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

9. 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.

10. Term Structure of Interest Rates

11. 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). . .

12. Unanticipated Inflation Premium
Consider a 1 yr. bond and a perpetuity
Bond
$1000
$50
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.

13. Unanticipated Inflation Premium
$1000
$50
$50
Bond
Perpetuity
Assume that the current market (nominal) rate of interest for these instruments is 5%, of which 2% is for expected inflation (πe) and re is 3%. We can easily calculate the price of each financial instrument:
Bond price = $1050/1.05 = $1000
Perpetuity price = $50/.05 = $1000

14. Unanticipated Inflation Premium
What happens to prices if actual inflation, , (say tomorrow) rises to 4%?
The bond price will fall to $1050/1.07 = $981.30
The perpetuity price falls to $50/.07 = $714.30
So, we may interpret the “normal” yield curve with respect to unanticipated inflation (ua):
Longer terms command higher yields to account for this asymmetric risk.

15. What if Inflation is Correctly Anticipated?
The yield curve will reflect that:
Maturity
Yield
Expect rising inflation
Expect falling inflation
Expect constant inflation
As with expected interest rate changes, no reason to favor one outcome here.

16. Negative Interest Rate Policy (Pardon me if I NIRP)
Central Banks start charging interest on bank reserves
-- A service fee?
-- Purpose? Stimulate lending/spending/econ. activity
Will the Federal Reserve follow suit?
-- They have been paying interest on reserves!
-- They just raised that interest rate!
-- Their policy is rooted in fear of spending!
Will bank depositors be next?
-- This will lead to Deposits and Cash!
-- This will raise transaction costs!
-- The next step – prohibit cash!

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