1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 6 Determining Market Interest Rates

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-2 Views of Bond Market We can view the buyer of bonds and the seller of bonds in 2 ways: 1) The bond is the good: the lender is buying the bond and the borrower is selling the bond. Price = amount lender pays 2) Use of funds is the good: the borrower is buying the use of funds and pays with a promise to repay. Price = interest rate

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-3 Buyer Lender buys the bondBorrower raising funds Borrower selling bond Lender supplying funds Bond priceInterest rate Seller Price Bond is the GoodUse of Funds is the Good

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-4 Figure 6.1 Demand for Bonds by Lenders

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-5 Figure 6.2 Supply of Bonds by Borrowers

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-6 Figure 6.3 Equilibrium in Markets for Bonds and Loanable Funds

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-7 Explaining Changes in Equilibrium Interest Rates Changes in bond demand or supply will change the bond price and interest rate. Theory of portfolio allocation can explain bond demand curve shifts. Changes in willingness and ability to borrow shifts the supply curve.

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-8 Figure 6.4 Shifts in the Demand for Bonds

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-9 Factors Shifting Increasing Bond Demand Higher wealth Higher expected returns on bonds Lower expected inflation Lower expected return on other assets Lower relative riskiness of bonds Higher relative liquidity of bonds Lower relative information costs of bonds

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-10 Factors Increasing Bond Supply Higher expected profitability of capital Lower business taxes Lower expected inflation Higher government borrowing

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-11 Figure 6.5 Shifts in the Supply of Bonds

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-12 Figure 6.6 Interest Rate Changes in an Economic Downturn

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-13 Figure 6.7 Expected Inflation and Interest Rates

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-14 The International Capital Market and the Interest Rate Closed Economy: an economy that neither borrows nor lends to foreign countries Open Economy: capital is mobile internationally World real interest rate (r w ): the interest rate that is determined in the international capital market

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-15 Figure 6.8 Flow of Funds in an Open Economy

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-16 Open Economies Small open economy: the quantity of loanable funds supplied is too small to affect the world interest rate and the economy takes rw as given Large open economy: an economy that is large enough to affect the world interest rate

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-17 Figure 6.9 Determining the Real Interest Rate in a Small Open Economy

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-18 Figure 6.10 Determining the Real Interest Rate in a Large Open Economy

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-19 Table 6.1 Factors That Shift the Demand Curve for Bonds

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-20 Table 6.2 Factors That Shift the Supply Curve for Bonds