1. THE BEHAVIOR OF INTEREST RATES
Chapter 5 – EC311 Susanto
THE BEHAVIOR OF INTEREST RATES

2. Determinants of Asset Demand
An asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:
Wealth, the total resources owned by the individual, including all assets.
Expected return (the return expected over the next period) on one asset relative to alternative assets.
Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets
If returns on two assets are equal, risk-averse people will prefer the lower-risk asset.
4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets.
An asset is liquid if the market in which it is traded has depth and breadth (many sellers and buyers).
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3. EXAMPLE 1: Expected Return
What is the expected return on an Exxon-Mobil bond if the return is 12% two-thirds of the time and 8% one-third of the time?
Solution
The expected return is 10.68%.
Re = p1R1 + p2R2
where
p1 = probability of occurrence of return 1 = 2/3 = .67
R1 = return in state 1 = 12% = 0.12
p2 = probability of occurrence return 2 = 1/3 = .33
R2 = return in state 2 = 8% = 0.08
Thus
Re = (.67)(0.12) + (.33)(0.08) = = 10.68%
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4. Determinants of Asset Demand
Wealth:
Increase in wealth  increased demand for ‘normal’ assets.
Expected return:
Higher RETe on a particular asset
 increased demand for that asset
 decreased demand for other (alternative) assets.
Risk:
Increase in an asset's risk (relative to other assets)
 decreased demand for that asset
 increased demand for other assets
Liquidity:
Increase in an asset's liquidity (relative to other assets)
 decreased demand for other assets
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5. Determinants of Asset Demand
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6. Demand and Supply of Bonds
Recall that, all else equal: PBOND ↓ if i ↑
That is, for any particular type of bond, the market market price P is inversely related to the market interest rate (yield to maturity) on this type of bond.
Why??
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7. The Demand Curve Let’s start with the demand curve.
Let’s consider a one-year discount bond with a face value of $1,000. In this case, the return on this bond is entirely determined by its price. The return is, then, the bond’s yield to maturity.
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8. Derivation of Demand Curve
Point A: if the bond was selling for $950.
Point B: if the bond was selling for $900.
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9. Derivation of Demand Curve
How do we know the demand (Bd) at point A is 100 and at point B is 200?
Well, we are just making-up those numbers. But we are applying basic economics – more people will want (demand) the bonds if the expected return is higher.
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10. Derivation of Demand Curve
To continue …
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
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11. 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
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12. Supply and Demand Analysis of the Bond Market
Market Equilibrium
1. Occurs when Bd = Bs, at P* = $850, i* = 17.6%
2. When P = $950, i = 5.3%, Bs > Bd (excess supply): P  to P*, i to i*
3. When P = $750, i = 33.0, Bd > Bs (excess demand): P  to P*, i  to i*
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13. Market Conditions
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
Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price
Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price
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14. Loanable Funds Terminology
1. Demand for bonds = supply of loanable funds
2. Supply of bonds = demand for loanable funds
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15. Changes in Equilibrium Interest Rates
We now turn our attention to changes in interest rate. We focus on actual shifts in the curves. Remember: movements along the curve will be due to price changes alone. The shifting of the entire demand or supply curve are is caused by a factor (or a combination of factors) other than price. First, we examine shifts in the demand for bonds. Then we will turn to the supply side.
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16. Shifts in the Bond Demand Curve
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17. Factors that Shift the Bond Demand Curve
1. Wealth
A. Economy grows, wealth , Bd , Bd shifts out to right
2. Expected Return
A. i  in future, Re for long-term bonds , Bd shifts out to right
B. e , Relative Re , Bd shifts out to right
C. Expected return of other assests , Bd , Bd shifts to left
3. Risk
A. Risk of bonds , Bd , Bd shifts out to right
B. Risk of other assets , Bd , Bd shifts out to right
4. Liquidity
A. Liquidity of Bonds , Bd , Bd shifts out to right
B. Liquidity of other assets , Bd , Bd shifts out to right
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18. Shifts in the Demand for Bonds
Wealth: In a business cycle expansion with growing wealth, the demand for bonds rises; in a recession, when income and wealth are falling, the demand for bonds falls.
2. Expected returns: higher expected interest rates in the future decrease the demand for long-term bonds; lower expected interest rates in the future increase the demand for long-term bonds.
3. Risk: as a bond’s riskiness increases, the demand for bonds to fall; if the riskiness of alternative assets (like stocks) increases (relative to bonds), the demand for bonds to rise.
4. Liquidity: increased liquidity of the bond market results in an increased demand for bonds; increased liquidity of alternative asset markets lowers the demand for bonds.
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19. Factors that Shift Demand Curve for Bonds
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20. Shifts in the Bond Supply Curve
1. Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right
2. Expected Inflation
e , Bs , Bs shifts out to right
3. Government Activities
Deficits , Bs , Bs shifts out to right

21. Factors that Shift Supply Curve for Bonds
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22. Shifts in the Supply Curve
1. Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right.
Expected Inflation
πe , Bs , Bs shifts out to right
3. Government Activities
Deficits , Bs , Bs shifts out to right
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23. Shifts in the Supply of Bonds
Expected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls
Expected Inflation: an increase in expected inflation causes the supply of bonds to increase
Government Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds
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24. Changes in πe: The Fisher Effect
If πe 
Relative Re , Bd shifts in to left
Bs , Bs shifts out to right
P , i 
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25. Summary of the Fisher Effect
If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls.
The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase.
When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls.
Since the bond price is negatively related to the interest rate, this means that the interest rate will rise.
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26. Evidence on the Fisher Effect in the United States
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27. Business Cycle Expansion
Wealth , Bd , Bd shifts out to right
Investment , Bs , Bs shifts right
If Bs shifts more than Bd then P , i 
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28. Evidence on Business Cycles and Interest Rates
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29. Relation of Liquidity Preference Framework to Loanable Funds
Keynes’s Major Assumption
Two Categories of Assets in Wealth: Money and Bonds
1. Thus: Ms + Bs = Wealth
2. Budget Constraint: Bd + Md = Wealth
3. Therefore: Ms + Bs = Bd + Md
4. Subtracting Md and Bs from both sides:
Ms – Md = Bd – Bs
Money Market Equilibrium
5. Occurs when Md = Ms
6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd = Bs and bond market is also in equilibrium
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30. Liquidity Preference Analysis
Derivation of Demand Curve
1. Keynes assumed money has i = 0
2. As i , relative RETe on money  (equivalently, opportunity cost of money )  Md 
3. Demand curve for money has usual downward slope
Derivation of Supply curve
1. Assume that central bank controls Ms and it is a fixed amount
2. Ms curve is vertical line
Market Equilibrium
1. Occurs when Md = Ms, at i* = 15%
2. If i = 25%, Ms > Md (excess supply): Price of bonds , i  to i* = 15%
3. If i =5%, Md > Ms (excess demand): Price of bonds , i to i* = 15%
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31. Money Market Equilibrium
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32. Rise in Income or the Price Level
1. Income , Md , Md shifts out to right
2. Ms unchanged
3. i* rises from i1 to i2
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33. Rise in Money Supply 1. Ms , Ms shifts out to right 2. Md unchanged
3. i* falls from i1 to i2
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35. Money and Interest Rates
Effects of money on interest rates
1. Liquidity Effect
Ms , Ms shifts right, i 
2. Income Effect
Ms , Income , Md , Md shifts right, i 
3. Price Level Effect (Liquidity framework)
Ms , Price level , Md , Md shifts right, i 
4. Expected Inflation Effect (Loanable funds framework)
Ms , e , Bd , Bs , Fisher effect, i 
Effect of higher rate of money growth on interest rates is ambiguous
1. Because income, price level and expected inflation effects work in opposite direction of liquidity effect
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36. Does Higher Money Growth Lower Interest Rates?