2/8/2018

BEHAVIOR OF
INTEREST RATES

Econ-190.2: Monetary, fiscal, and development policy

Determinants of asset demand

Purchasing and holding an asset or choosing which asset

to buy may depend on the following factors:

1. wealth – total resources owned by the individual,

including all assets;
2. expected return – the return expected over the next
period on one asset relative to alternative assets;
3. risk – the degree of uncertainty associated with the
return on one asset relative to alternative assets; and
4. liquidity – the ease and speed with which an asset can
be turned into cash relative to alternative assets.

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Determinants of asset demand

Theory of asset demand

1. The quantity demanded of an asset is positively related
to wealth.
2. The quantity demanded of an asset is positively related
to its expected return relative to alternative assets.
3. The quantity demanded of an asset is negatively related
to the risk of its returns relative to alternative assets.
4. The quantity demanded of an asset is positively related
to its liquidity relative to alternative assets.

Supply and demand in the bond market

Loanable funds framework
• It determines the equilibrium interest rate using the
supply of and demand for bonds.
Demand curve
• There exists an inverse relationship between bond price and
quantity. At lower prices (higher interest rates), ceteris paribus,
the quantity demanded of bonds is higher.

Supply curve
• There exists a positive relationship between bond price and
quantity. At lower prices (higher interest rates), ceteris paribus,
the quantity supplied of bonds is lower.

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Supply and demand in the bond market

Figure 1. Supply and demand for bonds

Source: Mishkin (2004)

Supply and demand in the bond market

Market equilibrium
• Occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to
sell (supply) at a given price.
• Bd = Bs defines the equilibrium (or market clearing) price
and interest rate.
• When Bd > Bs, there is excess demand, price will rise and
interest rate will fall.
• When Bd < Bs, there is excess supply, price will fall and
interest rate will rise.

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Changes in equilibrium interest rates

Shifts in the demand for bonds
• Wealth: in an expansion with growing wealth, the
demand curve for bonds shifts to the right

• Expected returns: higher expected interest rates in the

future lower the expected return for long-term bonds,
shifting the demand curve to the left

• Expected inflation: an increase in the expected rate of

inflation lowers the expected return for bonds, causing
the demand curve to shift to the left

Changes in equilibrium interest rates

Shifts in the demand for bonds
• Risk: an increase in the riskiness of bonds causes the
demand curve to shift to the left

• Liquidity: increased liquidity of bonds results in the

demand curve shifting right

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Changes in equilibrium interest rates

Figure 2. Shift in the demand curve for bonds

Source: Mishkin (2004)

Changes in equilibrium interest rates

Shifts in the supply of bonds
• Expected profitability of investment opportunities: in
an expansion, the supply curve shifts to the right

• Expected inflation: an increase in expected inflation

shifts the supply curve for bonds to the right

• Government budget: increased budget deficits shift the

supply curve to the right

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Changes in equilibrium interest rates

Figure 3. Shift in the supply curve for bonds

Source: Mishkin (2004)

Changes in equilibrium interest rates

Figure 4. Response to a change in expected inflation

Price of bonds Interest rate
(P increases ↑) (i increases ↓)

Quantity of bonds

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Changes in equilibrium interest rates

The Fisher effect

When expected inflation rises, interest rates will
rise.
πe↑ ⇒ i↑

Changes in equilibrium interest rates

Figure 5. Response to a business cycle expansion

Price of bonds Interest rate
(P increases ↑) (i increases ↓)

Quantity of bonds

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Changes in equilibrium interest rates

Response to a business cycle expansion

• In a business cycle expansion, the amounts of goods and services
being produced in the economy rise, so national income increases.
When this occurs, businesses will be more willing to borrow, because
they are likely to have many profitable investment opportunities for
which they need financing. Hence the quantity of bonds that firms
want to sell (that is, the supply of bonds) will increase.
• As the business cycle expands, wealth is likely to increase, and then
the theory of asset demand tells us that the demand for bonds will
rise as well.
• However, depending on whether the supply curve shifts more than
the demand curve or vice versa, the new equilibrium interest rate can
either rise or fall.

Supply and demand in the market for money

Liquidity preference framework
• Developed by John Maynard Keynes, the liquidity
preference framework is an alternative model in
determining equilibrium interest rates, this time in terms
of the supply of and demand for money.
• Although the two frameworks look different, the
liquidity preference analysis of the market for money is
closely related to the loanable funds framework of the
bond market.

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Supply and demand in the market for money

Liquidity preference framework
• The starting point of Keynes’s analysis is his assumption
that there are two main categories of assets that
people use to store their wealth: money and bonds.

+ = +
 The quantity of bonds and money supplied must
equal the quantity of bonds and money demanded.

The equation above can be rewritten as:

− = −
 If market for money is in equilibrium, the bond
market is also in equilibrium.

Supply and demand in the market for money

Figure 6. Equilibrium in the market for money

Source: Mishkin (2004)

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Supply and demand in the market for money

Liquidity preference framework
Downward-sloping demand for money

• As the interest rate increases:

- the opportunity cost of holding money increases
- the relative expected return of money decreases

• … and the quantity demanded for money

decreases.

Changes in equilibrium interest rates in LPF

Shifts in demand for money

• Income effect: a higher level of income causes
the demand for money at each interest rate to
increase and the demand curve to shift to the
right

• Price-level effect: a rise in the price level causes

the demand for money at each interest rate to
increase and the demand curve to shift to the
right

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Changes in equilibrium interest rates in LPF

Figure 7. Response to an increase in income or price

level
Interest
rate, i

Quantity of money, M

Changes in equilibrium interest rates in LPF

Shifts in supply of money

• Assume that the supply of money is controlled
by the central bank.

• An increase in the money supply as directed by

the central bank will shift the supply curve of
money to the right.

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Changes in equilibrium interest rates in LPF

Figure 8. Response to an increase in money supply

Interest
rate, i

Quantity of money, M

Changes in equilibrium interest rates in LPF

Price-level and expected inflation effect

• An increase in the money supply can also cause the overall price level
in the economy to rise. The liquidity preference framework predicts
that this will lead to a rise in interest rates. So the price-level effect
from an increase in the money supply is a rise in interest rates in
response to the rise in the price level.

• An increase in the money supply may lead people to expect a higher

price level in the future—hence the expected inflation rate will be
higher. The loanable funds framework has shown us that this increase
in expected inflation will lead to a higher level of interest rates.
Therefore, the expected-inflation effect of an increase in the money
supply is a rise in interest rates in response to the rise in the
expected inflation rate.

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Changes in equilibrium interest rates in LPF

Price-level versus expected inflation effect

• A one time increase in the money supply will cause prices to rise to a
permanently higher level by the end of the year. The interest rate will
rise via the increased prices.

• Price-level effect remains even after prices have stopped rising.

• A rising price level will raise interest rates because people will expect
inflation to be higher over the course of the year. When the price level
stops rising, expectations of inflation will return to zero.

• Expected-inflation effect persists only as long as the price level

continues to rise.

Changes in equilibrium interest rates in LPF

Price-level versus expected inflation effect

• The basic difference between the two effects, then, is

that the price-level effect remains even after prices
have stopped rising, whereas the expected-inflation
effect disappears.

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Changes in equilibrium interest rates in LPF

Money supply growth rate and interest rates

• Liquidity preference framework leads to the conclusion

that an increase in the money supply will lower interest
rates: the liquidity effect.

• Income effect finds interest rates rising because

increasing the money supply is an expansionary
influence on the economy (the demand curve shifts to
the right).

Changes in equilibrium interest rates in LPF

Money supply growth rate and interest rates

• Price-level effect predicts an increase in the money

supply leads to a rise in interest rates in response to the
rise in the price level (the demand curve shifts to the
right).

• Expected-inflation effect shows an increase in interest

rates because an increase in the money supply may
lead people to expect a higher price level in the future
(the demand curve shifts to the right).

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Changes in equilibrium interest rates in LPF

Figure 9. Response over time to an increase in money

supply growth (first possible outcome)

Source: Mishkin (2004)

Changes in equilibrium interest rates in LPF

Figure 10. Response over time to an increase in money

supply growth (second possible outcome)

Source: Mishkin (2004)

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Changes in equilibrium interest rates in LPF

Figure 11. Response over time to an increase in money

supply growth (third possible outcome)

Source: Mishkin (2004)

END

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