1. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 4 UNDERSTANDING INTEREST RATES (2)

2. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main2 The behavior of interest rates What determines the quantity demanded of an asset? –Wealth (total resources owned) –Expected return of one asset relative to alternative assets –Risk (the degree of uncertainty associated with the return) –Liquidity (the ease and speed with which an asset can be turned into cash)

3. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main3 The demand for bonds We consider a one-year discount bond, paying the owner the face value of €1,000 in one year. If the holding period is one year, the return on the bond is equal the interest rate i. It means: i = r = (F-P)/P If the bond price is €950, r = 5.3% We assume a quantity demanded at that price of €100 billion.

4. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main4 The demand for bonds If the price falls, say to €900, the interest rate increases (to 11.1%). Because the return on the bond is higher, the demand for the asset will rise, say to €200 billion, etc.

5. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main5 The demand for bonds 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond (€) 100 500 400300200

6. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main6 The supply for bonds 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond (€) 100 500 400300200

7. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main7 Market equilibrium (asset market approach) 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond (€) 100 500 400300200 C P* i*

8. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main8 Market equilibrium Equilibrium occurs at point C, where demand and supply curves intersect. P* is the market-clearing price, and i* is the market-clearing interest rate. If the P  P*, there is “excess supply” or “excess demand” of bonds. The supply and demand curves can be brought into a more conventional form:

9. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main9 A reinterpretation of the bond market Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d

10. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main10 Why do interest rates change? If there is a shift in either the supply or demand curve, the equilibrium interest rate must change. What can cause the curves to shift? –Wealth –Expected return –Risk –Liquidity

11. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main11 Example: Increase in risk, and demand for bonds If the risk of a bond increases, the demand for bonds will fall for any level of interest rates. It means that the supply of loanable funds is reduced. It is equivalent to a leftward shift of the supply curve.

12. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main12 A shift of the supply curve of funds Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d C D

13. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main13 Effects on the supply of funds for bonds Wealthright Expected interest left Expected inflation left Riskleft Liquidityright Change in variable Change in quantity Change in interest rate Shift in supply curve

14. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main14 The supply of bonds Some factors can cause the supply curve for bonds to shift, among them –The expected profitability of investment opportunities –Expected inflation –Government activities

15. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main15 Example: Higher profitability and supply of bonds If the profitability of a firm increases, the supply for corporate bonds will increase for any level of interest rates. It means that the demand of loanable funds increases. It is equivalent to a rightward shift of the demand curve.

16. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main16 A shift of the demand curve for funds Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d C D

17. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main17 Effects on the demand of funds for bonds Profitabilityright Expected inflation right Government activities right Change in variable Change in quantity Change in interest rate Shift in demand curve

18. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main18 Expected inflation: The “Fisher effect” If expected inflation increases, both curves are affected: –The supply of bonds (demand for funds) shifts to the right –The demand for bonds (supply of funds for bonds) shifts to the left When expected inflation increases, the interest rate will rise (“Fisher effect”).

19. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main19 The “Fisher effect” Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d C D

20. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main20 Government activities If government expands its debt (level of assets), this is tantamount to increasing its demand for loanable funds. It will increase the interest rate. In order to contain this effect, the EU member states have introduced the “Maastricht budget criteria”: –Level of government debt < 60% of GDP –Annual budget deficit < 3% of GDP

21. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main21 Maastricht budget criteria: Comparison

22. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main22 France and Germany

23. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main23 The Maastricht budget criteria The purpose is to limit the impact of government borrowing on interest rates. France, and Germany are violating the deficit criterion. Violation of the criteria may entail sanctions (fines)

24. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main24 The market for EMU government bonds (1997)

25. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main25 Supply and demand for money An alternative model to the loanable funds theory is the model developed by J.M. Keynes: the liquidity preference theory. It determines the equilibrium rate of interest in terms of supply and demand for money. John Maynard Keynes (1883-1946)

26. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main26 Starting point of liquidity preference There are only two assets that people use to store wealth: money and bonds. It implies that Wealth = B + M, or B s + M s = B d + M d, or B s - B d = M d - M s If the money market is in equilibrium, the bond market is also in equilibrium. Keynes assumes that money earns no interest.

27. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main27 Opportunity costs of money The amount of interest (expected return) sacrificed by not holding the alternative asset (here: bond) represents the opportunity costs of holding money. As interest rate rise (ceteris paribus), the expected return on money falls relative to the expected return on bonds. As these cost of holding money increase, the demand for money falls.

28. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main28 Equilibrium in the market for money Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C

29. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main29 Shifts in the demand for money curve Keynes considers two reasons why the demand for money curve could shift: –income; –and the price level As income rises –wealth increases and people want to hold more money as a store of value –people want to carry out more transactions using money.

30. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main30 Income and price-level effect A higher level of income causes the demand for money to increase and the demand curve to shift to the right. Changes in the price level: Keynes took the view that people care about the real value of money. If the price level increases, the real value of money falls: People want to hold a greater amount of money to restore their holdings in real terms.

31. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main31 Response to a change in income Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D

32. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main32 Response to a change in the money supply It is assumed that the central bank controls the total amount of money available. The supply of money is “totally inelastic”. However the central bank can gear the money supply by political intervention. If the money supply increases, the interest rate will fall (liquidity effect).

33. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main33 Response to a change in money supply Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D

34. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main34 Secondary effects of increased money supply If the money supply increases this has a secondary effect on money demand As we have seen: –it has an expansionary effect on the economy and raises income and wealth. -> interest rates increase (income effect). –it causes the overall price level to increase -> interest rates increase (price effect). –it affects the expected inflation rate -> interest rates increase (Fisher-effect).

35. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main35 Should the ECB lower interest rates? Politicians often ask the ECB to expand the money supply in order to promote a cyclical upturn (to combat unemployment). The liquidity effect does in fact reduce the level of interest rates! But the induced effects on money demand, –the income effect, –the price-level effect, and –the expected inflation effect allincrease the level of interest rates.

36. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main36 Increase of money supply plus demand shift 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D Interest rate (%) E

37. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main37 Growth of money (M3)

38. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main38 Short-term interest rates

39. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main39 Longer-term interest rates

40. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main40 Interest rate spreads “The” interest rate is an abstraction. In the real world there are many interest rates. Interest rates differ notably with respect to the maturity of the underlying loan. Long-term interest rates are less affected by short-term monetary policy. They typically attract a higher return than short-term lending.

41. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main41 The term structure of interest rates (USA)

42. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main42 The term structure for MFI interest rates