2 FINANCIAL MARKETS AND INTEREST RATES

2.1 THE MONEY MARKET

The market in interest bearing securities is usually split into the money and bond markets. The
money market is the market for the issue and trading of short-term securities, and the bond or
capital market the market is the market for the issue and trading of long-term securities.

The markets can also be distinguished as primary or secondary markets. The primary market is
that in which the securities are traded between the original borrower and lender, and the
secondary market is that where securities are traded between different lenders, so that the
original borrower is not involved in the trade. For our purposes, we will be concentrating on the
secondary market.

Money Market Instruments

A few of the main instruments traded in the money market are banker’s acceptances, treasury
bills, government bonds, negotiable certificates of deposit and repurchase agreements.

Banker’s Acceptances

A banker’s acceptance is a bill of exchange which is drawn on and accepted by a bank.

A bill of exchange is defined as an order on writing, addressed by one party to another,

instructing the party to whom it is addressed to make a payment of a stated amount on demand
or at some fixed or determinable future date.

They were originally created to enable sellers to obtain cash as soon as possible after dispatch of
the goods, and for the buyer to delay actual payment until after the goods had been received or
sold. The seller would then sell the bill to some holder of surplus funds (at a discount).

There were originally technical problems related to the physical distance between buyers and
sellers, as well as the quality of the bills (where, for example, the buyer was not known and the
bill therefore became difficult to negotiate.

These problems were circumvented by both buyers and sellers who required temporary finance
drawing bills on their banks, who undertook to pay them after a certain period. The drawers
would then endorse the bills, thereby making them payable to bearer, and sell them in the money
market. The bank would at the same time issue a letter of credit which, inter alia, required the
drawer to transfer funds to the bank on the date of maturity of the bill.

There is an active secondary market in banker’s acceptances.

Treasury Bills

Treasury bills represent a claim on the assets of the government, and are issued for the purpose
of raising short-term funds.

They are issued with a given nominal value and do not entail any payment of interest. When
they are bought, either originally or by subsequent investors, they are sold at a discount.
Government Bonds

Government bonds are fixed-interest-bearing securities issued by the central government with
maturities between one an twenty five years.

The face value and interest rate payable are specified on the bond, as are the periods at which
interest will be paid.

Negotiable Certificates of Deposit

NCD’s are fixed deposit receipts issued by a bank for periods of up to three years. They have a
fixed maturity date, nominal value and interest rate specified, and are tradable in the money
market.

Repurchase Agreements

A repurchase agreement is the sale of a security with an undertaking by the seller to repurchase
the security at a fixed date in the future at a price specified at the time of the original sale. They
are entered into for periods between one day and one year.

The Relationship between Money and Capital Markets

There is no clear-cut distinction between the money and capital markets. For example, a long-
term bond which had five years to run to maturity would be regarded as a bond market
instrument, but once the tenor is shorter than three years it becomes a money market instrument.

2.2 THE CAPITAL MARKET

This is not the market for physical capital, but rather for the financial instruments that confer
claims to financial capital. As indicated above, the capital market would normally be for trade in
financial instruments with more than three years to run to maturity. As with the money market,
there are both primary and secondary capital markets.

The main instruments traded in the capital market are fixed interest securities, variable interest
securities and shares.

Fixed Interest Securities

Public sector fixed interest securities are issued by government and other state bodies in the form
of bonds. Private sector fixed interest securities take the form mainly of debentures issued by
companies.

Variable Interest Securities

Loan contracts normally specify a variable interest rate, and these remain an affair solely
between the original borrower and lender. There is no secondary market in variable interest
securities, with the exception of participation mortgage bonds in which the bond managers
repurchase the bonds after five years. The reason for a lack of a secondary market is that the
uncertainty of the variable pattern of income makes it impossible to establish a present
discounted value of the future stream of earnings.
Shares

These are generally known as equities. The stock market provides a mechanism through which
the conflicting requirements of investors/businessmen and savers. The entrepreneur requires the
funds for a long period in order to invest in plant and machinery, but the saver prefers to keep
funds in a more liquid form. The stock market provides a mechanism through which savers can
liquidate their holdings at any time by selling them to other savers.

2.3 INTEREST RATES

Interest rates are an important price in any economy. They affect household decisions to as to
whether to consume or save, and whether the savings will be held in the form of cash (in savings
accounts) or bonds. Investment decisions of businesses are also affected by interest rates.

When we use the term interest rate in economics, the measure which is being referred to is the
yield to maturity, which (as will be seen) is the most accurate measure of interest rates.

Measuring Interest Rates

Credit market instruments fall into four broad types:

Simple loans require the repayment of the capital borrowed on maturity of the loan together with
an additional amount known as the interest payment. Commercial loans to businesses are often
of this type.

Fixed payment loans require a regular payment of the same amount monthly, which includes
both capital redemption and interest. Hire purchase finance is a typical example of this type of
instrument.

Coupon bonds pay the holder of the bond a fixed interest payment at regular intervals until
maturity when the face value or par value is repaid. Treasury and corporate bonds are examples
of this type of instrument.

Discount bonds, also known as zero-coupon bonds are bought at a price below the face value of
the bond, and the face value is repaid on maturity. For this reason there is no interest payment
on these bonds. Treasury bills and long term government bonds are examples of this type of
instrument.

Present Value

Present value is based on the commonsense notion that R100 today is worth more than R100 in a
year’s time; the money can be deposited and earn interest over the period so that it is worth more
at the end of the period than the original amount deposited.

In the case of simple loans, the simple interest rate is best expressed by dividing the interest
payment by the amount of the loan:

i = R10/R100 = 0.10 = 10%

If R100 was loaned for a year at 10%, at the end of the year the lender would receive:
 R100 x (1 + 0.10) = R110

If the R110 was lent out for a further year, at the end of the second year the lender would
receive:

R100 x (1 + 0.10) = R121

or equivalently

R100 x (1 + 0.10) x (1 + 0.10) = R100 x (1 + 0.10)2 = R121

This generalizes to

R100 x (1 + 0.10)n

where n is the number of years for which the loan is made.

Reversing the process, referred to as discounting the future, for a two year loan would be given
by:

R100 = R121/(1 + 0.10)2

More generally, the present value (PV) or present discounted value of R1 received n years in the
future when the simple interest rates is i is given by:

PV = R1/(1 + i)n (1)

Yield to Maturity

The most important way of calculating interest rates is the yield to maturity, which is the interest
rate that equates the present value of future payments from a debt instrument with its value
today.

Simple loans. Using the example above, the present value of the loan made is R100 and the
future value is R110. We can use equation 1 to calculate the yield to maturity i by recognizing
that the present value of the future payment must equal the current value of the loan:

R100 = R110/(1 + i)

Solving for i,

i = (R110 – R100)/R100

which is the simple interest rate on the loan.

For simple loans, the simple interest rate and the yield to maturity are equal.

Fixed Payment Loans. To calculate the yield to maturity we follow the same method as for a
simple loan by equating today’s value of the loan with its present value. Because a fixed
payment loan involves a stream of payments, we need to sum the present values of each of the
payments. Assuming the loan is R1000 and the annual payment is equal to R126 over a period
of 25 years:

R1000 = R126/(1 + i) + R126/(1 + i)2 + R126/(1 + i)3 + ……. + R126/(1 + i)25

More generally, for fixed payment loans

LV = FP/(1 + i) + FP/(1 + i)2 + FP/(1 + i)3 + ……. + FP/(1 + i)N

where: LV = loan value

FP = the fixed payment
N = number of years to maturity

For fixed payment loans the annual payment and the number of years to maturity are known, but
the yield to maturity is not. However, the yield to maturity i can be solved from the equation.
This is not a simple calculation, but tables are provided and most modern calculators are
programmed to make the calculation quickly.

Coupon Bonds. Calculation of the yield to maturity on a coupon bond is similar to that for a
fixed payment loan, the only difference being that the capital on a coupon bond is repaid in full
on maturity. Generally, the present value of coupon bonds is given by:

Pb = C/(1 + i) + C/(1 + i)2 + C/(1 + i)3 + ….. + C/(1 + i)N + F/(1 + i)N

where: Pb = the price of the coupon bond

C = yearly coupon payment
F = the face value of the bond
N = years to maturity

Once again, the equation can be solved for i but is more easily obtained by using bond tables or
programmed calculators.

As i, the yield to maturity, increases, the denominators in all of the terms on the right hand side
become larger and the price of the bond must fall. Alternatively, an increase in interest rates
means that the future coupon payments and final payment of capital must be worth less when
discounted back to present value, and hence the price of the bond must fall.

When the coupon bond is priced at its face value, the yield to maturity will be equal to the
coupon rate. When the bond price falls below its face value, the yield to maturity is greater than
the coupon rate.

Discount Bonds. The yield to maturity calculation for discount bonds is similar to that used for
simple loans. Suppose that a bond which will pay a face value of R1000 in one year is bought
for R900. Equating the present value of the bond to the purchase price, and using equation 1:

R900 = R1000/(1 + i), and solving for i

i = (R1000 – R900)/R900 = 0.111 + 11.1%

More generally, the yield to maturity for any one year discount bond is written as:
 i = (F – Pd)/Pd

where: F = face value of the discount bond

Pd = the current price of the discount bond

It can be seen again here that the yield to maturity is negatively related to the current bond price;
an increase in Pd will reduce i.

Interest Rates and Returns

How well an investor does by holding a bond or other security over a period of time is measured
more accurately by the rate of return than the interest rate. The rate of return is defined as the
payments to the owner of the bond plus the change in its value expressed as a fraction of the
purchase price. Consider a bond with a face value of R1000 and a coupon rate of 10% which is
sold for R1200. The rate of return would be given by:

[R100 + R200]/R1000 = 0.30 = 30%

a very different figure from the initial yield to maturity of only 10%. More generally, this can be
expressed as

RET = (C + Pt+1 – Pt)/Pt

where: RET = the return from holding the bond for the period t to t+1
Pt = price of the bond at time t
Pt+1 = price of the bond at time t+1
C = coupon payment

A few key features are true of all bonds:

• The only bond whose return equals the initial yield to maturity is one whose time to
maturity is the same as the holding period.

• A rise in interest rates is associated with a fall in the price of bonds whose holding period
is shorter than the term to maturity.

• The more distant a bond’s maturity, the greater the extent of the price change associated
with an increase in interest rates.

• The more distant a bond’s maturity, the lower the rate of return that occurs as a result of
the increase in the interest rate.

• Even if a bond has a high initial rate of interest, its return can turn out to be negative if
interest rates rise.

Maturity and Volatility of Bond Returns: Interest Rate Risk

Prices and returns for longer term bonds are more volatile than those for shorter term bonds.
Long term bonds are thus quite risky investments, and this is referred to as interest rate risk.

There is obviously no risk for an bond whose holding period is the same as the time to maturity,
since the payment on maturity is fixed in nominal terms.
Real and Nominal Interest Rates

The real interest rate is the nominal interest rate adjusted for expected changes in the price level,
so that it more accurately reflects the true cost of borrowing. The real interest rate is defined by
the Fisher Equation:

i = ir + e which, on rearrangement, gives

i r = i - e

The Fisher equation introduces the possibility of negative real interest rates. When real interest
rates are low there are greater incentives to borrow and fewer incentives to lend.

The same distinction can be made between nominal and real rates of return.

The distinction between nominal and real interest rates is important because the real rate of
interest is likely to be a better indicator of incentives to borrow and lend.

The Theory of Portfolio Choice

The theory of portfolio choice is important in the study of the determination of interest rates,
providing an outline of the determinants of how total wealth is divided between various types of
assets.

The Determinants of Asset Demand

An asset is some piece of property that serves as a store of value, and can take various forms.
Money, bonds, art, houses and manufacturing machinery are all assets.

The decision on whether to purchase an asset or not, and if so, which type, depends on a number
of factors:

• Wealth, or the total resources owned by an individual, including all assets currently held.
• Expected Return on one asset relative to alternative assets.
• Risk, or the degree of uncertainty associated with the return on one asset relative to
others.
• Liquidity, or the ease with which an asset can be turned into cash relative to alternative
types of assets.

Wealth. An increase in the value of wealth will generally lead to an increase in the demand for
all assets. The rate at which demand for various types of assets increases differs, however, and
the degree of response is measured by a concept known as the wealth elasticity of demand. This
is defined as:

Wealth Elasticity of Demand = %QD/%W

Asset can be sorted into two categories, depending on whether their wealth elasticity of demand
is greater or less than one.

An asset is defined as a necessity if there is only so much that people wish to hold, so that the
percentage increase in demand for the asset is smaller than the percentage increase in wealth, as
wealth increases. The wealth elasticity of demand for this type of asset is generally less than
one.

An asset is a luxury if the demand for it grows more than proportionally to the increase in
wealth, so that an increasing proportion of wealth is held in the form of these assets. The wealth
elasticity of demand for this type of asset is greater than one.

Stocks and bonds are examples of luxury assets, while cash and checking account balances are
examples of necessities.

Ceteris paribus, an increase in wealth will increase the demand for an asset, and the increase in
demand is greater if the asset is a luxury than if it is a necessity.

Expected Returns. The purchase of an asset is influenced by the expected return on that asset.
For example, if the return on a corporation bond is 10% half of the time and 15% the other half
of the time, the expected return over its lifetime will be 15%. If the expected return on an asset
increases relative to that on other assets, ceteris paribus, the demand for that asset will increase.
The relative expected return can increase either by an increase in the expected return on the asset
concerned or by a decrease in expected returns on other assets.

Ceteris paribus, an increase in an asset’s expected return relative to other assets will increase
the demand for that asset.

Risk. The degree of risk concerning an asset’s returns will also affect the demand for that asset.
Consider two types of assets, one which has a return of 15% half of the time and 5% the other
half, making its expected return 10%, and another which has a fixed return of 10% - there is a
greater risk associated with holding the former than the latter. Even though the expected returns
on the two are the same, the risk averse investor (which most people are) will prefer the latter
asset.

Ceteris paribus, an increase in an asset’s risk relative to that of other assets will reduce the
demand for that asset.

Liquidity. An asset is liquid if it is traded in a market that has both depth and breadth, that is one
in which there are many buyers and sellers and where the transaction costs are low. Real assets
such as houses are not very liquid, while financial assets such as treasury bills are.

Ceteris paribus, the more liquid an asset is relative to other assets the more desirable it will be,
and the greater the demand will be.

The Theory of Portfolio Choice assembles the above factors: the demand for an asset is
positively related to wealth, with the extent of the change in demand being determined by
whether the asset is a luxury or a necessity. The demand for an asset relative to other assets is
positively related to the relative expected return and liquidity of that asset, and negatively related
to the relative risk.
3 THE DETERMINATION AND BEHAVIOUR OF INTEREST RATES

3.1 THE LOANABLE FUNDS MODEL – SUPPLY AND DEMAND IN THE BOND
MARKET

We assume here that there is only one type of security (one-year discount bonds), and hence
only one interest rate. This assumption will be relaxed later when we examine the term structure
of interest rates.

The Demand Curve

We examine the relationship between the price of the bond (and therefore the rate of interest)
and quantity demanded ceteris paribus. With no coupon payments made and the full face value
of the bond repaid on maturity, if the bond is held for the full term the expected return on the
bond is given by:

i = RETe = (F – Pd)/Pd

where: i = interest rate = yield to maturity

RETe = expected return
F = face value of the discount bond
Pd = initial purchase price of the discount bond

A particular value of the interest rate corresponds to each bond price and, as indicated earlier,
they are negatively related to each other. The relationship between expected return and the
demand for the bonds can be illustrated as follows:

Since we are measuring both the price of the bond and the corresponding interest rate, we
require two vertical axes. Bond prices are measured in the conventional way with an increase
being showing in an upward direction. Since interest rates are negatively related to the price of
bonds, an increase is shown in a downward direction.

Ceteris paribus, an increase in the price of bonds and a corresponding decrease in the interest
rate will cause a decline in the quantity demanded of bonds.

The Supply Curve

Once again, the relationship between the price of bonds (and therefore the interest rate) and the
quantity supplied is examined, ceteris paribus. The supply curve is drawn with its normal
positive slope – the lower the interest rate the less costly it is to borrow money by issuing bonds,
and the more bonds will be issued.

Market Equilibrium

As usual, this will occur at the price (and interest rate) where the demand for and the supply of
bonds are equal.

At any price above equilibrium the excess supply will drive the price of bonds down. Similarly,
at any price below equilibrium the excess demand will drive the price of bonds up. The
adjustment in the price of bonds, and (in the opposite direction) in interest rates, will continue
until equilibrium is found.
The more conventional way of conducting demand and supply analysis is with one vertical axis
only and, since interest rates are usually of more concern than bond prices, we will take the
vertical axis to measure interest rates. Similarly, an increase in interest rates will be shown by a
movement up the axis.

This introduces a complication, in that the demand and supply curves are reversed with regard to
their normal positions. Since an increase in interest rates involves a decrease in price, however,
the curves make sense with the slopes as given.

An alternative way of addressing the problem would be to leave the demand and supply curves
with their conventional slopes, but rename the horizontal axis. Supplying a bond is equivalent to
demanding loanable funds, and the supply curve can thus be regarded as the demand curve for
loanable funds. Similarly, the demand for bonds can be regarded as the supply of loanable
funds. It is for this reason that the framework presented above is known as the loanable funds
framework.

Either of the two models can and will be used, but the results will be the same. An important
feature of the analysis here is that, unlike many markets where the analysis is conducted in terms
of flows, the asset market approach for analysing the behaviour of financial markets is always in
terms of stocks at a given point in time.

CHANGES IN EQUILIBRIUM INTEREST RATES

The usual distinction between movement along and shifts of the demand and supply curves must
be remembered here. Changes in the price of bonds, or equivalently, the interest rate, will cause
a movement along the curve. Changes in any other factors underlying demand and supply will
cause a shift of the relevant curve – a shift in either of the curves means that the amount of bonds
demanded/supplied at each interest rate has changed.

The theory of portfolio choice explained above supplies us with the reasons as to why the
demand curve may shift.

Shifts in the Demand for Bonds

WEALTH. A rapidly growing economy is normally associated with increasing wealth. If the
economy is in an expansionary phase, the demand for bonds would thus be increasing and the
demand curve shift to the right. Conversely, with the economy going into a recession with
income and wealth falling, the demand for bonds would decline and the demand curve shift to
the left.

The propensity to save can also affect wealth and hence the demand for bonds. An increase in
the propensity to save would lead to an increase in the demand for bonds and a shift of the
demand curve to the right. A decrease in the propensity to save would lead to a decrease in the
demand for bonds and a shift of the demand curve to the left.

EXPECTED RETURNS. With a one-year discount bond which is held to maturity the interest
rate and the expected return are identical. For maturities longer than one year, however, the
interest rate and the expected return need no longer be the same.

If an unanticipated increase in interest rates is expected, the expected return on longer term
bonds would fall (and could even become negative). Higher expected interest rates in the future
would lower the expected return on bonds, decrease the demand for bonds and shift the demand
curve to the left.

By contrast, an unanticipated decrease in interest rates would increase the expected return on
bonds. Lower expected interest rates in the future would increase the demand for long term
bonds and shift the demand curve to the right.

Changes in expected returns on other assets can also affect the demand curve for bonds. For
example, an expected boom on the stock market would mean that both capital gains and
expected returns on stocks would rise. The expected return on bonds would now be relatively
lower, and the demand curve would shift to the left.

A change in expected inflation is also likely to alter returns on real assets, such as houses and
cars. An increase in expected inflation would have the effect of increasing the prices on houses
and cars in the future, which would mean higher nominal capital gains. This relatively higher
return on real assets would cause the demand for bonds to fall.

An alternative way of looking at higher expected inflation is that the real interest rate on bonds
would decline, and this decline in the relative expected return would once again lead to a decline
in the demand for bonds.

An increase in the expected rate of inflation lowers the (relative) expected return on bonds,
causing the demand for bonds to decline and the demand curve to shift to the left.

RISK. An increase in the volatility of prices in the bond market means that the risk associated
with holding bonds increases and they become less attractive. An increase in the risk of holding
bonds would cause a decline in the demand for bonds and a shift of the demand curve to the left.

Conversely, an increase in the volatility of prices in any other asset market would make bonds
relatively more attractive. An increase in the riskiness of alternative assets causes the demand
for bonds to rise and the demand curve to shift to the left.

LIQUIDITY. An increase in the volumes traded in the bond market would mean that bonds are
easier to sell, and hence are more liquid. Any increase in the liquidity of bonds would mean that
more bonds are demanded at each interest rate, and the demand curve would shift to the right.

Conversely, increased liquidity of other assets will mean that the demand for bonds will decline,
and the demand curve shift to the left.

Liquidity, or the perception of it, could also be changed by such factors as brokerage charges and
capital gains tax placed on assets.

Shifts in the Supply of Bonds

Factors which are likely to cause shifts in the supply of bonds are:

• Expected profitability of investment opportunities

• Expected inflation
• Government activities

EXPECTED PROFITABILITY OF INVESTMENT OPPORTUNITIES. In a growing economy

firms will expect profits to be relatively higher, and would be more willing to issue additional
bonds in order to finance new investment. This would mean an increase in the supply of bonds
and a shift of the supply curve to the right.

EXPECTED INFLATION. For a given nominal interest rate, an increase in inflation would
reduce the real interest rate. Firms expecting an increase in inflation would thus be willing to
issue new bonds. An increase in expected inflation would lead to an increase in the supply of
bonds and a shift of the supply curve to the right.

GOVERNMENT ACTIVITIES. Government financing of a deficit is undertaken through the

issue of new bonds. Increasing deficits will thus mean an increase in the supply of bonds and a
shift of the supply curve to the right.

3.2 THE LIQUIDITY PREFERENCE FRAMEWORK

An alternative model for determining interest rates is by using the demand and supply of money
instead of that for bonds. This model was developed by Keynes, and is referred to as the
liquidity preference framework.

The starting point of the analysis is the Keynesian assumption that wealth was stored mainly in
two forms of assets, bonds and money. Total wealth in the economy must therefore equal the
total quantity of bonds plus the total quantity of money, which equals the quantity of bonds
supplied BS plus the quantity of money supplied MS. Since the total amounts of bonds and
money that people demand must also be equal to the total of wealth in the economy, the total
amount of money and bonds supplied must be equal to the total amount of bonds and money
demanded:

BS + MS = BD + MD, which can be rewritten as

BS - BD = MD - MS

If either one of the markets is in equilibrium the other must also be in equilibrium; in this sense
the liquidity preference framework is equivalent to the loanable funds framework, so that in
most instances the two approaches yield the same results.

In practice, since the liquidity preference framework assumes that there are only two types of
assets (bonds and money), any effects on interest rates that arise from changes in expected
returns on real assets (such as houses) are ignored.

Both approaches are used in examining the determination of interest rates. The loanable funds
framework is easier to use when examining the effects of changes in expected inflation, whereas
the liquidity preference framework is simpler to use when analysing the effects of changes in
income, the price level and changes in the supply of money.

In the liquidity preference framework, money is assumed to have a zero rate of return. This
would be true for currency and, although demand deposits may earn interest, it is minimal, so
that the assumption is not too drastic a departure from reality.

Bonds, as the only alternative to money in this framework, are assumed to have an expected
return equal to the interest rate i. (Keynes did not actually assume that the return on bonds was
equal to the interest rate, but rather that they were very closely related; the distinction will not
make any appreciable difference to the analysis.)
The negative relationship between the demand for money and the interest rate can be explained
using the concept of opportunity cost, the amount of interest/expected return that is sacrificed by
not holding an alternative asset. As the interest rate on bonds rises the opportunity cost of
holding money increases, so that the holding of money becomes less desirable and the quantity
demanded must fall.

At this point we assume that the Reserve Bank controls the supply of money at a fixed quantity,
so that the supply curve is a vertical line at that quantity. The equilibrium interest rate is given at
the intersection of the two curves.

At interest rates above equilibrium MS will be greater than MD. People are holding more money
in their portfolios than they desire at that interest rate and they will try to get rid of the excess by
trying to buy bonds. With the stock of bonds fixed at any point in time, the additional demand
will drive the price of bonds up and the interest rate down; with interest rates falling the quantity
demanded of money will increase along the curve until the equilibrium interest rate is reached.

At interest rates below equilibrium MD will be greater than MS. People are holding less money in
their portfolios than they desire, and will try to satisfy this additional demand by trying to sell
bonds. This will drive the price of bonds down and the interest rate up; with interest rates
increasing the quantity demanded of money will decrease along the curve until the equilibrium
interest rate is reached

CHANGES IN EQUILIBRIUM INTEREST RATES

SHIFTS IN THE DEMAND FOR MONEY

Keynes believed that two factors would cause the demand for money to shift; income and the
price level.

INCOME EFFECT. In an expanding economy with rising income wealth would increase, and
people would want to hold more money as a store of value. Secondly, with rising income people
would want to carry out more transactions, so that the transactions demand for money would
increase. A higher level of income would cause an increase in the demand for money and the
demand curve would shift to the right.

PRICE-LEVEL EFFECT. Keynes viewed the demand for money in real terms, so that an
increase in the price level (which would reduce the real value of money held) would lead to an
increase in the demand for nominal balances. A rise in the price level would lead to an increase
in the demand for money and a shift to the right of the demand curve.

SHIFTS IN THE SUPPLY OF MONEY

Although the process is a little more complex, we assume that shifts in the supply of money are
engineered by the Reserve Bank.

Changes in equilibrium interest rates would thus be the result of changes in income, the price
level (both affecting the demand for money) and the supply of money. There is a positive
relationship between interest rates and both the level of income and the price level, and a
negative relationship between interest rates and the supply of money, ceteris paribus.

The conclusion that an increase in the supply of money will always lead to a fall in interest rates
has been challenged by Milton Friedman.
He acknowledges that the liquidity preference analysis is correct, and refers to the decline in
interest rates as a result of an increase in the supply of money as the liquidity effect. He argues,
however, that the increase in the supply of money will not leave everything else constant and
that, depending on the strength of other induced effects, an increase in the money supply may
ultimately lead to an increase in interest rates. These other factors are the income effect, the
price-level effect and the expected inflation effect.

INCOME EFFECT. An increase in the money supply would have an expansionary effect on the
economy, raising both national income and wealth. The liquidity preference framework
unambiguously indicates an increase in interest rates as the demand for money increases. In the
loanable funds framework, both the demand (via the wealth effect) and the supply (via the
expected profitability of investment effect) for bonds will increase. The overall effect is
somewhat ambiguous in the loanable funds framework but, providing the increase in supply is
relatively larger, interest rates will increase.

PRICE-LEVEL EFFECT. An increase in the money supply can also cause the overall price level
in the economy to increase, and the liquidity preference framework indicates that this will lead to
an increase in the demand for money and hence interest rates.

EXPECTED-INFLATION EFFECT. An increase in the money supply may lead people to expect
higher prices in the future so expected inflation will increase. The loanable funds framework
indicates that this will lead to an increase in interest rates.

It may appear that the price-level effect and the expected-inflation effect are the same thing, but
there is a subtle difference between the two.

Suppose that there is a one-off increase in the money supply that will lead to a permanently
higher level of prices in one year’s time. As prices rise over the course of the year, interest rates
will rise via the price-level effect. Once prices have risen to their peak by the end of the year the
price-level effect will be at its maximum.

The rising price level will also increase interest rates via the expected-inflation effect because
people will expect inflation to be higher over the course of the year. Once the price level has
reached its maximum by the end of the year, inflation and the expected inflation rate will fall
back down to zero, and any rise in interest rates that occurred as a result of the earlier rise in
expected inflation will be reversed.

The price-level effect thus reaches its greatest impact at the end of the year, while the expected
inflation effect has its smallest (zero) impact at the end of the year. The price-level effect thus
remains even after prices have stopped rising, whereas the expected inflation effect disappears at
this time.

The point to note here is that the expected inflation effect lasts only while prices continue to rise.
A one-off increase in the money supply will not produce a continually rising price level; only a
higher rate of money supply growth will have that effect.

The eventual effect on interest rates will thus depend on which of the effects dominates – the
liquidity effect is the only one that will lead to a fall in interest rates, while the other three all
indicate an increase in interest rates.
The liquidity effect generally takes effect immediately as the rising money supply leads to a
decline in interest rates. The income and price-level effects take time to operate, while the
expected inflation effect may be slow or quick depending on how quickly people adjust their
expectations of inflation as the money supply is increased.

Liquidity effect larger than other effects – diagram 1. Interest rates fall quickly to their lowest
level due to the liquidity effect as the rate of growth in the money supply is increased at time T.
Over time, the other effects start to operate and reverse the decline but, because the liquidity
effect dominates, interest rates never get back to their initial level.

Liquidity effect smaller than other effects and inflationary expectations slow to adjust – diagram
2. Interest rates will initially fall via the liquidity effect, and then the other factors start to
counteract the initial drop. Because the liquidity effect has a relatively smaller impact, interest
rates eventually increase to above their initial level.

Liquidity effect smaller than expected inflation effect, and expected inflation quick to adjust –
diagram 3. The expected inflation effect begins to operate immediately and dominates the
liquidity effect, so that following the increased rate of growth in the money supply interest rates
start rising rather than falling. Over time the price-level and income effects come into play,
resulting in an outcome where the interest rate is substantially higher than its initial level.

The analysis provides the paradoxical result that, if a decrease in interest rates is desired and,
depending on circumstances, the money supply should be reduced.

Experience in the USA has been that rising rates of growth in the money supply have led to
increases in interest rates, so that the situation in diagram 1 is not plausible. The problem is then
to decide which of the other two best describes the situation, since they depend on the speed of
adjustment of inflationary expectations, and these are impossible to measure. Recent research
using sophisticated analysis has, however, indicated that an increase in the rate of growth of the
money supply will lead to an initial fall in interest rates such as that depicted in diagram 2.
4 THE RISK AND TERM STRUCTURE OF INTEREST RATES

We have so far assumed that there is only one interest rate, but also seen that a variety on
financial instruments exist on which interest rates can and do differ.

We first examine the risk structure of interest rates, which explains why bonds with the same
maturity have different interest rates, and then the term structure of interest rates which explains
the relationship between interest rates and the different terms to maturity.

4.1 THE RISK STRUCTURE OF INTEREST RATES

DEFAULT RISK. This refers to the risk that the issuer of the bond will be unable to meet
interest payments or pay off the face value of the bond on maturity.

Corporations suffering big losses may have to suspend interest payments on its bonds, so that the
default risk is or can become quite high on corporate bonds.

Government bonds are regarded as being default-free bonds, since the government can always
increase taxes or simply print money to meet its obligations. It should be remembered, however,
that calls to repudiate what has been called apartheid debt may mean that some bonds are not
default-free.

The spread between the interest rates on bonds with default risk and those that are default-free is
known as the risk premium, indicating the additional amount of interest that people will require
in order to be willing to hold a risky bond.

Suppose for simplicity that a corporate bond is initially regarded as being free of default risk, so
that the interest rate payable on these bonds is initially equal to that payable on government
bonds with the same maturity. The risk premium (iC – iG ) in this case will be zero.

Suppose now that the corporation is threatened with future losses, so that the risk of default on
their bonds is no longer zero and expected return relative to that on government bonds will
decrease. The effect of both of these factors will mean a shift of the demand curve for those
bonds to the left, and simultaneously a shift in the demand for government bonds to the right as
investors “flee to safety”.

The price on the corporate bonds will be driven down and the interest rate up, while the price on
government bonds will be driven up and the interest rate down. A risk premium has now opened
up, since iC – iG is no longer zero.

A bond with a default risk will always have a risk premium, and this risk premium will increase
as the default risk increases. Risk premiums would generally be expected to increase during
economic downturns when corporate profits are under threat. Stock market crashes are also
perceived as increasing the probability of default, and so the effects would be felt in both the
stock and bond markets. In the context of developing countries events such as the Asian Crisis
would have a similar effect.

The probability of default is important in determining the size of the risk premium, and various
investment advisory firms (such as Moody’s Investor Services and the Standard and Poor’s
Corporation provide information by rating the quality of bonds in terms of default risk. Bonds
with high default risk have been termed junk bonds.
LIQUIDITY. Another attribute of a bond that influences its interest rate is its liquidity, with
greater liquidity, ceteris paribus, making the bond more desirable. We can use the same model
that was used to examine default risk to analyse the effect of a reduction in liquidity of a bond.

If a corporate bond became less liquid because it was not as widely traded, demand would shift
away from corporate bonds to the now relatively more liquid government bonds. The effect, as
before, will be an increase in the spread between interest rates paid in the two security types.

The risk premium is thus increased by a liquidity premium and, although it should properly be
called a risk and liquidity premium, the term risk premium is by convention take to refer to both.

Income tax must also be taken into consideration when a differential treatment is applied to
different types of bonds, as this can distort the risk premium. For example, US municipal bonds,
although they have some default risk, carry lower interest rates than government bonds. This is
explained by the fact that the interest payments on municipal bonds are exempt from income tax,
which has the same effect as an increase in the relative expected return.

4.2 THE TERM STRUCTURE OF INTEREST RATES

We now examine how interest rates differ with the term to maturity on bonds which have
identical risk, liquidity and tax considerations.

A plot of the returns on bonds with these characteristics but with different maturities is called a
yield curve, and it describes the term structure of interest rates for particular types of bonds.

A positively sloped yield curve would reflect long-term interest rates that are higher than short-
term rates.

A flat yield curve would mean that long and short-term interest rates are the same.

A negatively sloped yield curve, sometimes referred to as an inverted yield curve, would reflect
long-term rates below short-term rates.

Yield curves may also have more complicated shapes, first sloping up and then down or vice-
versa, but these will not concern us here.

A good theory of the term structure of interest rates must explain three empirical facts:

• Interest rates on bonds of different maturities move together over time.

• When short-term interest rates are low, yield curves are more likely to have an upward
slope, and when short-term rates are high, yield curves are more likely to become
inverted.
• Yield curves almost always slope upwards.

Three theories have been advanced to explain the term structure of interest rates:

• The expectations hypothesis.

• The segmented markets theory.
• The preferred habitat theory, which is closely related to the liquidity premium theory.

The preferred habitat and liquidity premium theories do a good job of explaining all three of the
empirical features above, whereas the other two can both explain some but not all of the features.
The first two do, however, lay the groundwork for the third and a study of them will demonstrate
how economists adapt theories when predicted results conflict with evidence.

THE EXPECTATIONS HYPOTHESIS. The expectations hypothesis starts off with the
commonsense proposition that the interest rate on a long-term bond will equal the average of the
short-term interest rates that people expect to occur over the life of the long-term bond.

For example, if the expectation was that short-term interest rates would average 10% over the
next five years, but then begin increasing so that the average rate would be 11% over the next
ten years, then the rate on five year bonds would be 10% and on ten year bonds 11%. The
reason why interest rates on different maturities differ is thus that short-term interest rates are
expected to have different values at future dates.

A key assumption behind the theory is that people are indifferent between bonds of different
maturities, so that they will not hold any of a bond whose expected return is less than that of a
bond at a different maturity. Bonds of various maturities are thus perfect substitutes and all have
the same expected return.

For example, the investor would be indifferent between the following two investment strategies:

• purchase a one-year bond, hold it until maturity and then use the proceeds to purchase
another one-year bond.
• purchase a two-year bond and hold it until maturity.

Since both strategies must yield the same expected return for the investor to be indifferent
between the two, the interest rate on the two-year bond must equal the average of the two one-
year interest rates.

More generally, for an investment of R1 in the two-year bond which is held until maturity, the
expected return can be calculated as:

(1 + i2t)(1 + i2t) – 1 = 1 + 2i2t + (i2t)2 – 1, where

i2t = today’s (time t) interest rate on the two-period bond.

After the second period the R1 investment is worth (1 + i2t)(1 + i2t). Subtracting the initial
investment of R1 and dividing by R1 gives the rate of return. Since (i2t)2 is an extremely small
number it can be ignored, and the rate of return expressed as:

2i2t

With the other strategy in which one-period bonds are bought, the expected return on the R1
investment is:

(1 + it)(1 + iet +1) – 1

After the first period the R1 investment is worth (1 + it) which is reinvested for a second period
will yield an amount of (1 + it)(1 + iet +1). Subtracting the initial R1 and dividing through by R1
gives the expected return of holding one-period bonds for two periods. Multiplying the brackets
out and because it(iet + 1) is also extremely small and can be ignored, the rate of return simplifies
to:
 i + iet + 1

The investor will be indifferent between the two strategies only if the expected returns are equal:

2i2t = i + iet + 1

Solving for i2t in terms of one-period rates gives:

i2t = (i + iet + 1)/2

which tells us that the two-period rate must equal the average of the two one-period rates. For
longer maturities:

int = (it + iet + 1 + iet + 2 + ….. + iet + (n –1)) / n

A rising trend in expected short-term interest rates will produce an upward-sloping yield curve
along which interest rates rise as the maturity lengthens.

The expectations hypothesis provides an explanation of why the term structure of interest rates
changes over time. An upward-sloping yield curve suggests that short-term interest rates are
expected to rise, and when it becomes inverted, that they are expected to fall. It is only when the
yield curve is flat that short-term interest rates are not expected to change.

The hypothesis also explains the first and second of the empirically observed phenomena:

• Interest rates on different maturities tend to move together. Historically, if short-term

rates move up today they will tend to be higher in the future, and thus raise people’s
expectations of future short-term rates. Because long-term rates are the average of
expected short-term rates an increase in short-term rates will also raise long-term rates,
so that the rates on different maturities tend to move together.

• Yield curves tend to have an upward slope when short-term rates are low and become
inverted when they are high. When short-term rates are low, people generally expect
them to increase to some normal level in the future, so that the average of future expected
rates is high relative to the current rate. This means that the long-term rate must be
above short-term rates. Conversely, when short-term rates are high, people generally
expect them to fall to some normal level in the future, so that the average of future
expected rates is low relative to the current rate. This means that the long-term rate must
be below short-term rates.

What the expectations hypothesis cannot explain is why the yield curve is typically upward
sloping. This is a major shortcoming, since it suggests that short-term rates are always expected
to increase. Over sufficiently long periods, short-term rates are just as likely to come down as
the are to increase, so the expectations hypothesis would suggest that the typical yield curve is
flat rather than upward-sloping.

SEGMENTED MARKETS THEORY. As the name suggests, markets for different-maturity

bonds are seen as separate from and independent of each other, so that bonds of different
maturities are not substitutes for each other. The interest rate for any particular bond is
determined in the market for that bond, and has no effect on the expected returns on other bonds.
This is at the opposite extreme to the expectations hypothesis.
The theory is based on the notion that investors have strong preferences for bonds of particular
maturities, and they are therefore concerned with the rates of return on those maturities only.
With a particular holding period in mind, they can obtain a bond of that maturity with no risk* at
all.

* This is not strictly true, except in the case of a one-year discount bond, since the coupon
payments on long-term bonds must be reinvested at the ruling interest rate at the time.
Since this cannot be known with certainty in advance, there is some risk. This does not
disturb the generality of the argument, however, since the risk associated with
reinvestment of coupon payments is small relative to the risk of capital loss on
repayment of the principal, and this is eliminated by matching the holding period with
the maturity.

Differing yield curve patterns are explained by the segmented markets theory, since they are
accounted for supply and demand conditions in the different markets. If, as seems likely,
investors have short desired holding periods and generally prefer bonds with shorter maturities
since they carry less interest rate risk, the fact that yield curves typically slope upwards is
explained by the theory.

Because the demand for long-term bonds is typically lower than that for short-term bonds, prices
of long-term bonds will generally be lower and interest rates higher, so the yield curve should
typically slope upwards.

The theory has a major flaw, however, in that it cannot explain the first two phenomena:

Because markets are regarded as segmented, there is no reason why a change in rates in the
market for one maturity should have any effect on the rates for other maturities, and it cannot
thus explain why rates on different maturities tend to move together.

Further, because it is not clear from the theory how the demand and supply for short versus long-
term bonds changes as short-term interest rates change, it cannot explain why yield curves tend
to be upward-sloping when short-term rates are low and inverted when they are high.

The two theories explain all of the empirically observed facts between them, but neither explains
all of them together.

PREFERRED HABITAT THEORY. This theory of the term structure states that the interest rate
on a long-term bond will equal the average of the expected short-term rates over the life of the
bond, plus a liquidity premium that responds to supply and demand in the market for that bond.

The key assumption here is that bonds of different maturities are substitutes for each other, so
that expected returns on one bond does influence those on other bonds, but it allows investors to
have a preference for one maturity over another. The bonds are thus substitutes, but not perfect
substitutes.

Preferred habitat refers to the maturity in which the investor is most comfortable, but they still
watch expected returns on maturities other than their preferred habitat; they will not allow
returns in these other maturities to get too far out of line with the returns in the chosen maturity.
They will be willing to buy bonds in other maturities, but only if they are compensated with a
somewhat higher return, or positive term premium. The preferred habitat theory is thus written
as:
 int = (it + iet + 1 + iet + 2 + ….. + iet + (n –1)) / n + knt.

where knt = the term premium for the n-period bond at time t

Closely related to the preferred habitat theory is the liquidity premium theory, which takes a
more direct approach to modifying the expectations hypothesis.

The reasoning is that a positive liquidity premium must be offered to buyers of longer-term
bonds to compensate them for the higher interest rate risk. This leads to an equation identical to
that above, with the proviso that the term knt is always positive and rises with the term to
maturity of the bond.

Because of the presence of the liquidity premium, the theories predict a yield curve that rises
more steeply than that implied by the expectations hypothesis.

The preferred habitat and liquidity premium theories explain the empirically observed facts with
regard to the term structure of interest rates as follows:

• A rise in short-term interest rates indicates that short-term interest rates will, on average,
be higher in the future than the current rate. The first term in the equation then implies
that long-term interest rates will rise along with them. The fact that interest rates on
different maturities move together is thus explained by the two theories.

• When investors expect interest rates to rise to some normal level when they are low, the
average of future expected short-term rates will be high relative to the current short-term
rate. Long-term interest rates will thus be above short-term rates, and this is supported
by a positive liquidity premium; the yield curve will thus slope sharply upwards.
Conversely, if short-term rates are high people usually expect them to come down, so
that the average of the expected future short-term rates would be below the current short-
term rate. The long-term rate would, despite the positive liquidity premium, be well
below current short-term rates and the yield curve would become inverted. The fact that
yield curves have steep upward slopes when short-term rates are low and become
inverted when short-term rates are high is thus explained by the two theories.

• The typical upward slope of the yield curve is explained by the fact that, because of
investor’s preference for short-term bonds, the liquidity or term premium rises with the
maturity of the bonds. Even if interest rates are expected to stay the same on average in
future, the term or liquidity premium explains why long-term rates are above short-term
rates and the yield curve has a positive slope.

The occasional appearance of an inverted yield curve would be explained by the fact that, at
times, short-term interest rates are expected to fall so much that the presence of a positive term
premium is completely outweighed by the average of expected short-term rates being well below
the current short-term rate.

The preferred habitat and liquidity premium theories are particularly attractive in that they allow
for prediction of future short-term rates simply by looking at the slope of the yield curve.

• A steeply rising yield curve means that the short-term interest rates are expected to rise in
future.
• A moderately steep curve means that, if interest rates change at all, the rise or fall in
short-term rates will not be significant.
• A flat yield curve indicates that short-term rates are expected to fall slightly in the future.
• An inverted yield curve means that short-term rates are expected to fall sharply in future.