1. Copyright © 2002 Pearson Education, Inc. Slide 6-1 If we look at finance in terms of buying and selling claims, The Bond Is the Good Buyer: Lender who buys bond Seller: Borrower issuing bond Price: Bond price

2. Copyright © 2002 Pearson Education, Inc. Slide 6-2 Or, if we look at finance in terms of the supply and demand for loans, Use of Funds Is the Good Buyer: Borrower raising funds Seller: Lender supplying funds Price: Interest rate

3. Copyright © 2002 Pearson Education, Inc. Slide 6-3 Demand for Bonds  > Supply of Loans

4. Copyright © 2002 Pearson Education, Inc. Slide 6-4 Supply of Bonds  > Demand for Loans

5. Copyright © 2002 Pearson Education, Inc. Slide 6-5 Market Equilibrium

6. Copyright © 2002 Pearson Education, Inc. Slide 6-6 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.

7. Copyright © 2002 Pearson Education, Inc. Slide 6-7 Shifts in Bond Demand

8. Copyright © 2002 Pearson Education, Inc. Slide 6-8 Factors Increasing Bond Demand  Increasing Supply of Loans 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

9. Copyright © 2002 Pearson Education, Inc. Slide 6-9 Factors Increasing Bond Supply  Increasing Demand for Loans Higher expected profitability of capital Lower business taxes Lower expected inflation Higher government borrowing

10. Copyright © 2002 Pearson Education, Inc. Slide 6-10 Shifts in the Supply of Bonds

11. Copyright © 2002 Pearson Education, Inc. Slide 6-11 Do Interest Rates Fall During Recessions? Why?

12. Copyright © 2002 Pearson Education, Inc. Slide 6-12 Expected Inflation and Interest Rates

13. Copyright © 2002 Pearson Education, Inc. Slide 6-13 Flow of Funds in an Open Economy

14. Copyright © 2002 Pearson Education, Inc. Slide 6-14 International Capital Market and the Interest Rate In an open economy capital is mobile. The world real interest rate, r w, is determined in the international capital market.

15. Copyright © 2002 Pearson Education, Inc. Slide 6-15 Determining the Interest Rate in a Small Open Economy

16. Copyright © 2002 Pearson Education, Inc. Slide 6-16 Determining the Interest Rate in a Large Open Economy