Chapter 5

TheBehaviorof
InterestRates

Interest rates are negatively related

to the price of bonds
Ifwecanexplainwhybondpriceschange,
wecanexplainwhyinterestratefluctuate.
Toderiveademandcurveofassets,like
moneyorbonds,weusethetheoryofasset
demand.

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Determinants of Asset Demand

1. Wealth:thetotalresourcesownedbythe
individuals.
2. Expectedreturn:ononeassetrelativeto
alternativeassets
3. Risk:ononeassetrelativetoalternativeassets
4. Liquidity:relativetoalternativeassets

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Determinants of Asset Demand

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Derivation of Bond Demand Curve

(FP)
i=RET =
P
e

PointA:
P=$950
($1000$950)
i= =0.053=5.3%
$950
Bd=$100billion

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5-5

Derivation of Bond Demand Curve

PointB:
P=$900
i=

($1000$900)
=0.111=11.1%
$900

Bd=$200billion
PointC:P=$850,i=17.6%Bd=$300billion
PointD:P=$800,i=25.0%Bd=$400billion
PointE:P=$750,i=33.0%Bd=$500billion
DemandCurveisBdinFigure1whichconnectspointsA,B,C,D,E.
Hasusualdownwardslope

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Derivation of Bond Supply Curve

PointF:

P=$750,i=33.0%,Bs=$100billion

PointG: P=$800,i=25.0%,Bs=$200billion
PointC: P=$850,i=17.6%,Bs=$300billion
PointH: P=$900,i=11.1%,Bs=$400billion
PointI:

P=$950,i=5.3%,Bs=$500billion

SupplyCurveisBsthatconnectspointsF,G,C,H,I,andhasupward
slope

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Supply and
Demand
Analysis of
the Bond
Market
Market Equilibrium
d

1. Occurs when B = B , at P* =
$850, i* = 17.6%
s

2. When P = $950, i = 5.3%, B >

d
B (excess supply): P to P*, i
to i*
d

3. When P = $750, i = 33.0, B >

s
B (excess demand): P to P*,
i to i*

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Loanable Funds Terminology

1. Demandforbonds=
supplyofloanable
funds
2. Supplyofbonds=
demandforloanable
funds

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Changes in Equilibrium Interest Rates

Makethedistinctionbetween:
movementalongademand(orsupply)
curveandshiftsinademand(or
supply)curve.

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Shifts in the Bond Demand Curve

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Factors that Shift the Bond Demand Curve

1.Wealth
A. Economygrows,wealth,Bd,Bdshiftsouttoright
2.ExpectedReturn(expectedi,andexpected)
A. iinfuture,Reforlongtermbonds,Bdshiftsouttoright
B. e,expectedreturnofrealassets(physicalassets),relativeRe,Bd
shiftsouttoright
C. Expectedreturnofotherassets(ex.stocks),Bd,Bdshiftsouttoright
3.Risk
A. Riskofbonds(volatile),Bd,Bdshiftsouttoright
B. Riskofotherassets,Bd,Bdshiftsouttoright
4.Liquidity(morepeoplestartedtradingbonds)
A. LiquidityofBonds,Bd,Bdshiftsouttoright
B. Liquidityofotherassets,Bd,Bdshiftsouttoright

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Factors
that Shift
Demand
Curve for
Bonds

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Shifts in the Bond Supply Curve

1. Profitabilityof
Investment
Opportunities
Businesscycle
expansion,
investment
opportunities,
Bs,Bsshiftsout
toright
2. ExpectedInflation

e,Bs,Bsshifts
outtoright
3. Government
Activities
Deficits,Bs,Bs
shiftsouttoright

5-14

Factors that Shift the Bond Demand Curve

1. ProfitabilityofInvestmentOpportunities
Businesscycleexpansion,investmentopportunities,
Bs,Bsshiftsouttoright
2. ExpectedInflation

e,therealcostofborrowing,Bs,Bsshiftsoutto
right
3. GovernmentActivities
Deficits,Bs,Bsshiftsouttoright

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Factors
that Shift
Supply
Curve for
Bonds

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Changes in e: the Fisher Effect

Ife
1. RelativeRETe
,Bdshiftsinto
left
2. Bs,Bsshifts
outtoright
3. P,i

5-17

Evidence on the Fisher Effect

in the United States

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Business Cycle Expansion

1. Wealth,Bd,
Bdshiftsoutto
right
2. Investment,
Bs,Bsshifts
outtoright
3. IfBsshiftsmore
thanBdthenP
,i

5-19

Evidence on Business Cycles

and Interest Rates

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Relation of Liquidity Preference

Framework to Loanable Funds
KeynessMajorAssumption
TwoCategoriesofAssetsinWealth
Money
Bonds
1. Thus:

Ms+Bs=Wealth

2. BudgetConstraint:

Bd+Md=Wealth

3. Therefore:

Ms+Bs=Bd+Md

4. SubtractingMdandBsfrombothsides:
MsMd=BdBs
MoneyMarketEquilibrium
5. OccurswhenMd=Ms
6. ThenMdMs=0whichimpliesthatBdBs=0,sothatBd=Bsandbondmarketisalso
inequilibrium(WalrasLaw).

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1. Equatingsupplyanddemandforbondsas
inloanablefundsframeworkisequivalent
toequatingsupplyanddemandformoney
asinliquiditypreferenceframework
2. Twoframeworksarecloselylinked,but
differinpracticebecauseliquidity
preferenceassumesonlytwoassets,money
andbonds,andignoreseffectsoninterest
ratesfromchangesinexpectedreturnson
realassets(automobilesandhouses)
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Liquidity Preference Analysis

DerivationofDemandCurve
1. Keynesassumedmoneyhasi=0
2. Asi,relativeRETeonmoney(equivalently,opportunitycostofmoney
)Md
3. Demandcurveformoneyhasusualdownwardslope
DerivationofSupplycurve
1. AssumethatcentralbankcontrolsMsanditisafixedamount
2. Mscurveisverticalline
MarketEquilibrium
1. OccurswhenMd=Ms,ati*=15%
2. Ifi=25%,Ms>Md(excesssupply):Priceofbonds,itoi*=15%
3. Ifi=5%,Md>Ms(excessdemand):Priceofbonds,ito
i*=15%

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Money
Market
Equilibrium

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Shifts in the Demand for Money

IncomeEffect
Economyexpands,incomerises,wealthincreases,
peoplewillholdmoremoneyasastoreofvalueand
fortransactions
PriceLevelEffect
peoplecareabouttheamountofmoneytheyholdin
realterms.Whenthepricelevelrises,thesame
nominalquantityofmoneyisnolongerasvaluable

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Rise in Income or the Price Level

1. Income,Md,Md
shiftsouttoright
2. Msunchanged
3. i*risesfromi1toi2

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Shifts in the Supply of Money

Assumethatsupplyofmoneyis
completelycontrolledbythecentral
bank

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Rise in Money Supply

1. Ms,Msshiftsouttoright
2. Mdunchanged
3. i*fallsfromi1toi2

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5-29

Money and Interest Rates (Application, p.112)

Effectsofmoneyoninterestrates
1.LiquidityEffect(everythingelseremainingequal)
Ms,Msshiftsright,i
2.IncomeEffect
Ms,Income,Md,Mdshiftsright,i
3.PriceLevelEffect
Ms,Pricelevel,Md,Mdshiftsright,i
4.ExpectedInflationEffect(ahigherrateofmoneysupplygrowth)
Ms,e,Bd,Bs,Fishereffect,i
Effectofhigherrateofmoneygrowthoninterestratesisambiguous
1. Becauseincome,pricelevelandexpectedinflationeffectsworkinopposite
directionofliquidityeffect

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Does
Higher
Money
Growth
Lower
Interest
Rates?

5-31

Evidence on Money Growth

and Interest Rates

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