1. Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015

2. Chapter 5 The Behavior of Interest Rates

3. Bond Demand P D The quantity of bonds demanded increases as p falls. B

4. Bond Demand D The quantity of bonds demanded increases as p falls. Bond demand increases in Expected return relative to other assets Liquidity relative to other assets Wealth P B

5. The quantity of bonds demanded increases as p falls. Bond demand increases in Expected return relative to other assets Liquidity relative to other assets Wealth Bond demand decreases in Riskiness relative to other assets Expected inflation Expected interest rate Bond Demand D P B Expected return relative to other assets For 1-year discount bonds held for 1 year, R = i

6. S Bond Supply P The quantity of bonds supplied increases as p rises. B

7. Bond supply increases in Expected profitability of investment opportunities Expected inflation Government budget deficits Bond Supply S P B

8. Supply and Demand D P B S Excess supply: the price suppliers are asking for is too high 95 15 25

9. Supply and Demand D P B S Excess supply: the price suppliers are asking for is too high For a zero-coupon $100 bond held for one year 95 i 100 95 5.3 15 25

10. Supply and Demand D P B S Equilibrium: the quantities of bonds supplied and demanded equal For a zero-coupon $100 bond held for one year 95 15 25 92 20 i 5.3

11. Supply and Demand D P B S Equilibrium: the quantities of bonds supplied and demanded equal For a zero-coupon $100 bond held for one year 95 92 20 i 5.3 100 92 8.7

12. Supply and Demand D P B S Excess demand: the price suppliers are asking for is low For a zero-coupon $100 bond held for one year 90 15 25 i 5.3 8.7 95 92

13. Supply and Demand D P B S Excess demand: the price suppliers are asking for is low For a zero-coupon $100 bond held for one year i 100 90 11.1 90 15 25 5.3 8.7 95 92

14. Supply and Demand D P B S Equilibrium: the quantities of bonds supplied and demanded equal For a zero-coupon $100 bond held for one year i 11.1 90 15 25 5.3 8.7 95 92 20

15. The Fisher Effect D P B S Suppose expected inflation rise by 6 percentage-points. i 5.3 95 20

16. The Fisher Effect D P B S Suppose expected inflation rise by 6 percentage-points. i 15 5.3 8.7 95 92 20 D

17. The Fisher Effect D P B S Suppose expected inflation rise by 6 percentage-points. i 11.1 90 15 5.3 8.7 95 92 20 S D The nominal rate of interest rises by 5.8 pct. pts.

18. Source: Mishkin (1981) “The Real Interest Rate: An Empirical Investigation” Carnegie-Rochester Conference Series on Public Policy 15: 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends. The Fisher Effect

19. Source: FREDFRED The Fisher Effect

20. Source: FREDFRED The Fisher Effect

21. The Business Cycle and Interest Rates S P D i 5.3 95 B 18 Suppose economic growth is accelerating.

22. The Business Cycle and Interest Rates S P B D i 23 5.3 8.7 95 92 18 S Suppose economic growth is accelerating.

23. The Business Cycle and Interest Rates Suppose economic growth is accelerating. The quantity and price of bonds both increase S P B D i 23 5.3 8.7 95 92 18 S D 23 7.5 93

24. The Business Cycle and Interest Rates Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm. The quantity and price of bonds both increase

25. = 0 if bond market in equilibrium = 0 if loanable funds market in equilibrium Keynes’ liquidity preference framework i 8.7 Bond Market B 92 BD BS Loanable funds Market LS LD P L 15 holding money and buying bonds are the only stores of wealth the quantity of loanable funds people and firms supply = the value of bonds purchased Total Wealth = B s + M s = B d + M d B s – B d =M s – M d = 0 if the market for money is in equilibrium

26. Keynes’ liquidity preference framework holding money and buying bonds are the only stores of wealth the quantity of loanable funds people and firms supply = the value of bonds purchased Loanable funds Market 15 8.7 LS LD i L 15 8.7 LS LD i L

27. Keynes’ liquidity preference framework. Loanable funds Market 15 8.7 LS LD i L i MD M holding money and buying bonds are the only stores of wealth the quantity of loanable funds people and firms supply = the value of bonds purchased The interest rate in these markets are the same The market for money

28. 15 8.7 LS LD i L. Loanable funds Market i MD M The market for money 7.5 Money supply shifts to the right (increases) if o The Fed injects money into the banking system with OMP o Banking lending increases The Liquidity Effect

29. B 95 BD BS P L 15 5.3 LS LD i L i MD M Bond MarketLoanable funds MarketThe market for money 92 8.7 5.3 8.7 A one time increase in MS permanently raises the price level by end of year: i = r +  o bond demand falls because the return falls o bond supply rises because the cost of borrowing falls o money demand increases (the supply of loanable funds falls) (demand for loanable funds rises) The Price-level Effect

30. An increase in MS causes inflation expectations to rise, which may diminish over time. o bond demand falls (the supply of loanable funds falls) o bond supply rises (demand for loanable funds rises) o money demand increases 15 5.3 LS LD i L i MD M Loanable funds MarketThe market for money The Expected-Inflation Effect 5.3 8.7

31. An increase in MS is an expansionary influence on the economy. o demand for loanable funds rises o money demand increases 15 5.3 LS LD i L i MD M Loanable funds MarketThe market for money The Income Effect 5.3 7.1

32. Figure 11 Response to an Increase in MS Growth The Total Effect

33. Figure 11 Response to an Increase in MS Growth The Total Effect

34. Figure 12 Annual M2 Growth and 3-month T-bill (1950–2011) Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt. The Total Effect 2 2 3 3 4 4 5 5 6 6 8 8 9 9 a a 1 1 b b 7 7

35. Chapter 6 Interest Rate Determination

36. Nominal Rate (i)= Real Rate (r) +Expected Inflation (  e ) +Default Risk Premium (  ) +Illiquidity Risk Premium ( ) –Tax exemption discount (  ) +Maturity Premium (i nt – i t ) +Liquidity Premium (l nt )

37. Interest Rate Determination Nominal Rate (i)= Real Rate (r) +Expected Inflation (  e ) +Default Risk Premium (  ) +Illiquidity Risk Premium ( ) –Tax exemption discount (  ) Risk structure

38. The Risk and Term Structures of Interest Rates Risk structure: Bonds with the same maturity (n) have different interest rates because of – default risk premium () – illiquidity risk premium () – income tax risk discount () Term structure: For bonds with identical characteristics, the interest rate (i) increases as maturity (n) increases – maturity premium (i nt – i t ) – liquidity premium (l nt ) – The yield curve is the relationship between i and n.

39. Risk Structure Default risk premium Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value o U.S. Treasury bonds are considered default free o Default risk premium (  ) is the spread between the interest rates on bonds with default risk and the interest rates on Treasury bonds, holding, , n, l nt, and i nt – i t equal

40. TABLE 1 Risk Structure Default risk premium

41. Corporate Bond Market U.S. Treasury Bond Market PPii 9505 DcDc DtDt QQ Risk Structure Default risk premium ScSc StSt 9505

42. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc QQ Risk Structure Default risk premium 9505 5 6925 DtDt

43. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ Risk Structure Default risk premium 9505 5 6 4 975 925

44. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ Risk Structure Default risk premium 6 4 975 925 2

45. Pre-bailout N = 1 I% = A PV = -1068 PMT = 100 FV = 1000 Post-bailout N = 1 I% = A PV = -1023 PMT = 100 FV = 1000 You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout. Risk Structure Default risk premium

46. Pre-bailout N = 1 I% = 2.996 PV = -1068 PMT = 100 FV = 1000 Post-bailout N = 1 I% = 7.527 PV = -1023 PMT = 100 FV = 1000 You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout. Risk Structure Default risk premium

47. Liquidity is the relative ease with which an asset can be converted into cash o Cost of selling a bond o Number of buyers/sellers in a bond market o Illiquidity risk premium ( ) is the spread between the interest rate on a bond that is illiquid and the interest rate on Treasury bonds, holding , , n, l nt, and i nt – i t equal. o E.g., assume an investor is looking at buying two corporate bonds that have the same coupon rates and maturities, but only one is traded on a public exchange. The investor is not be willing to pay as much for the non-public bond. The difference in yields the investor is willing to pay for each bond is the liquidity premium. Risk Structure Illiquidity risk premium

48. Corporate Bond Market U.S. Treasury Bond Market PPii 9505 DcDc DtDt QQ ScSc StSt 5 Risk Structure Illiquidity risk premium

49. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc QQ 9505 5 6925 DtDt Risk Structure Illiquidity risk premium

50. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 9505 5 6 4 975 925 Risk Structure Illiquidity risk premium

51. Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 6 4 975 925 2 Risk Structure Illiquidity risk premium

52. Treasury N = 1 I% = A PV = -1058 PMT = 80 FV = 1000 Corporate N = 1 I% = A PV = 1001 PMT = 80 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds. Risk Structure Illiquidity risk premium

53. Risk Structure Illiquidity risk premium Treasury N = 1 I% = 2.079 PV = -1058 PMT = 80 FV = 1000 Corporate N = 1 I% = 7.892 PV = 1001 PMT = 80 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds.

54. Income tax considerations o Interest payments on municipal bonds are exempt from federal income taxes. o Tax exemption risk discount (  ) is the spread between the interest rate on a tax exempt municipal bond and the interest rate on Treasury bonds, holding ,, n, l nt, and i nt – i t equal. o The discount shrinks if o federal income taxes are lowered or there is talk of doing so o politicians seriously consider ending the exemption o the exemption is repealed. Risk Structure Tax exemption risk discount

55. Municipal Bond Market U.S. Treasury Bond Market PPii 9505 DtDt DmDm QQ ScSc StSt 5 Risk Structure Tax exemption risk discount

56. U.S. Treasury Bond Market PPii ScSc StSt DtDt DtDt QQ 9505 5 6925 DmDm Risk Structure Tax exemption risk discount Municipal Bond Market

57. U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DmDm QQ 9505 5 6 4 975 925 Risk Structure Tax exemption risk discount Municipal Bond Market

58. U.S. Treasury Bond Market PPii ScSc StSt DtDt DtDt DtDt DtDt QQ 6 4 975 925 -2 Risk Structure Tax exemption risk discount Municipal Bond Market

59. Tax-free municipal N = 1 I% = 3.5 PV = A PMT = 80 FV = 1000 Risk Structure Tax exemption risk discount Corporate N = 1 I% = 3.5 PV = A PMT = 40 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate of 50%.

60. Risk Structure Tax exemption risk discount Tax-free municipal N = 1 I% = 3.5 PV = -1043.48 PMT = 80 FV = 1000 Corporate N = 1 I% = 3.5 PV = -1004.83 PMT = 40 FV = 1000

61. Figure 1—Long-Term Bond Yields, 1919–2011 Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm. Risk Structure

62. Interest Rate Determination Nominal Rate (i)= Real Rate (r) +Expected Inflation (  e ) +Default Risk Premium (  ) +Illiquidity Risk Premium ( ) –Tax exemption discount (  ) +Maturity Premium (i nt – i t ) +Liquidity Premium (l nt )

63. Interest Rate Determination Nominal Rate (i)= Real Rate (r) +Expected Inflation (  e ) +Default Risk Premium (  ) +Illiquidity Risk Premium ( ) –Tax exemption discount (  ) +Maturity Premium (i nt – i t ) +Liquidity Premium (l nt ) Risk structure Term structure

64. Term Structure Time to maturity affects interest rates because – Time increases exposure to risk, causing investors to demand higher yields on securities with longer maturities. The term structure of interest rates refers to difference in the yields on instruments that are identical except for term to maturity. Term structure is represented graphically by a yield curve. – Yield curves consider only the relationship between maturity or term of a security and its yield at a moment in time, otrs.

65. Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time Term Structure

66. Figure 4—Interest rate movements on Treasuries with different maturities Sources: Federal Reserve; www.federalreserve.gov/releases/h15/data.htm. Term Structure

67. Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time 2.When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3.Yield curves almost always slope upward Term Structure

68. 68 February 4, 2005 Term Structure

69. Figure 7 Yield Curves for U.S. Government Bonds Term Structure

70. Figure 6 Term Structure

71. Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time 2.When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3.Yield curves almost always slope upward Term Structure Three Theories that explain these facts 1.Segmented markets theory explains fact three but not the first two 2.Expectations theory explains the first two facts but not the third 3.Liquidity premium theory combines the two theories to explain all three facts

72. Term Structure maturity premium Expectations theory says the yield on a long-term bond equals the average of the short-term interest rates people expect to occur over its life – Maturity Premium is the spread between the interest rates on bonds with n years and 1 year to maturity, holding ,, , and l nt equal. i nt – i t – Buyers of bonds o do not prefer bonds of one maturity over another o do not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity o consider bonds with different maturities to be perfect substitute

73. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

74. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

75. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

76. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

77. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

78. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

79. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

80. Graph the maturity adjusted yields over maturity Term Structure maturity premium i n

81. Graph the maturity adjusted yields over maturity Term Structure maturity premium i n maturity premium for a 1-year bond 0%

82. Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 2-year bond 0.325%

83. Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 3-year bond 0.57%

84. Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 4-year bond 0.7675%

85. Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 5-year bond 0.93%

86. Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 6-year bond 1.06%

87. Term Structure Expectations Theory i n Yield Curve

88. Term Structure liquidity premium The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond Bonds of different maturities are partial (not perfect) substitutes – Liquidity premium is the spread between the interest rates on bonds with n and one years to maturity, holding ,, , and i nt – i t equal l nt

89. Suppose the liquidity premium is linear in maturity: l nt = 0.08n Term Structure liquidity premium

90. Term Structure Expectations Theory Yield Curve

91. Term Structure Liquidity Premium Theory Yield Curve

92. Nominal Rate (i)= Real Rate (r) +Expected Inflation (  e ) +Default Risk Premium (  ) +Illiquidity Risk Premium ( ) –Tax exemption discount (  ) +Maturity Premium (i nt – i t ) +Liquidity Premium (l nt ) Interest Rate Determination Risk structure Term structure