Eco 362 Module 5

ECO 362 MODULE 5
BEHAVIOUR OF
INTEREST RATES
• interest rates experience substantial fluctuations
• need to provide some answers to why this happens
• how is the overall level of interest rates determined and which factors
influence their behavior
(A) Determinants of Asset Demand
• (1) Wealth:
Ø total resources owned by the individual, including all assets.
Ø holding everything else constant, an increase in wealth raises the quantity demanded of an
asset.
• (2) Expected return:
Ø the return expected over the next period on one asset relative to alternative assets.
Ø an increase in an asset’s expected return relative to that of an alternative asset, holding
everything else unchanged, raises the quantity demanded of the asset.
• (3) Risk:
Ø the degree of uncertainty associated with the return on one asset relative to alternative
assets.
Ø holding everything else constant, if an asset’s risk rises relative to that of alternative assets,
its quantity demanded will fall.
• (4) Liquidity:
Ø the ease and speed with which an asset can be turned into cash relative to alternative assets.
Ø the more liquid an asset is relative to alternative assets, holding everything else unchanged,
the more desirable it is, and the greater will be the quantity demanded.
(A) Determinants of Asset Demand
• Theory of Asset Demand: states that holding all of the other factors
constant:
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
(B) Supply and Demand in the Bond Market:
The Loanable Funds Framework
• first step is to obtain a bond demand curve, which shows the
relationship between the quantity demanded and the price when all
other economic variables are held constant.
• (1) Demand Curve
• consider the demand for 1-year discount bonds which make no
coupon payments but pay the owner the N10,000 face value in a year.
• if the holding period is 1 year, the return on the bonds is known
absolutely and is equal to the interest rate as measured by the yield
to maturity.
- this means that the expected return on this bond is equal to the interest
rate i, which is:
i = RETe = F –P
P
where i = interest rate = yield to maturity

RETe = expected return
F = fare value of the discount bond
P = initial purchase price of the discount bond
- this formula shows that a particular value of the interest rate corresponds
to each bond price.
- if the bond sells for N9,500, the interest rate and expected return is
N10,000 - N9,500 = 0.053 = 5.3%
N9,500
• at this 5.3% interest rate and expected return corresponding to a bond price of
N9,500, let us assume that the quantity of bonds demanded is N100 billion (point
A)
• to display both the bond price and the corresponding interest rate, the figure has
2 vertical axis.
• left vertical axis shows the bond price
• right vertical axis shows the interest rate
• the right and left vertical axes run in opposite directions because bond price and
interest rate are always negatively related.
- at a price of N9,000, the interest rate and expected return equals
N10,000 - N9,000 = 0.111 = 11.1%
N9,000
Figure: SS and DD for Bonds
Price of Bonds, P (N)

Interest Rate, i (%)
(P increases )
(i increases )
A
9,500
5.3
I
B
9,000 11.1
H
C
P* = 8,500
I* = 17.6
D
8,000
G
7,500 33
F E
Bd
100 200 300 400 500
Qty of Bonds (B)

(N billions)
• equilibrium in bond market occurs at point C, the intersection of the demand curve Bd and bond
SS curve Bs
• equilibrium price is N8,500
• equilibrium interest rate is 17.6%
• at P = N9,000, higher expected return
• because the expected return on these bonds is higher, with all other economic variables held
constant, the quantity demanded of bonds will be higher as predicted by the theory of asset
demand
• point B shows that the quantity of bonds demanded at the price of N9,000 has risen to N200
billion
• if the bond price is N8,500, the interest rate and expected return is 17.6%, quantity bonds
demanded (point C) will be greater than at point B
• at lower prices of N8,500 (interest rate = 25%) and N7,500 (interest rate = 33.3%), the quantity of
bonds demanded will be even higher (points D and E)
• the curve Bd, which connects these points, is the demand curve for bonds
• at low prices of the bond, quantity demanded is higher.
• (2) Supply Curve
• when the price of the bonds is N7,500 (interest rate = 33.3%), point F
shows that the quantity of bonds supplied is N100 billion
• if the price is N8,000, the interest rate is the lower rate of 25%
• because at this interest rate it is now less costly to borrow by issuing
bonds, firms will be willing to borrow more through bond issues, and the
quantity of bonds supplied is at the higher level of N200 billion (point G)
• an even higher price of N8,500, corresponding to a lower interest rate of
17.6%, results in a larger quantity of bonds supplied of N300 billion (point
C)
• higher prices of N9,000 and N9,500 result in even greater quantities of
bonds supplied (points H and I)
• the Bs, which connects these points, is the supply curve for bonds.
• (3) Market Equilibrium
• in the bond market, equilibrium is achieved when the quantity of bonds
demanded equals the quantity of bonds supplied.
• Bd = Bs ………………………..….…………….………….…….(1)
• equilibrium occurs at point C, where demand and supply curves intersect at
a bond price of N8,500 (interest rate of 17.6%) and a quantity of bonds of
N300 billion
• P* = N8,500 = equilibrium or market-clearly price
• i* = 17.6% = equilibrium or market-clearly interest rate
• it is easy to see what happens at any point other than C
• (4) Changes in Equilibrium Interest Rates
• the analysis examines how the demand and supply curves shift in
response to changes in variables – what effects these have on the
equilibrium value of interest rates.
• (4.1) Shifts in the Demand for Bonds
• the theory of asset demand provides a framework for deciding which
factors cause the demand curve for bonds to shift.
• these factors include changes in 4 parameters:
• (1) Wealth:
Øin a business cycle expansion with growing wealth, the demand for bonds
rises and the demand curve for bonds shifts to the right
Øin a recession when income and wealth are falling, the demand for bonds
falls, and the demand curve shifts to the left.
• (2) Expected Returns on Bonds Relative to Alternative Assets:
Øhigher expected interest rates in the future lower the expected return for long-term
bonds, decrease the demand, and shift the demand curve to the left
Øa rise in the interest rate on a long term bond would lead to a fall in price and
negative return
Ølower expected interest rates in the future increase the demand for long-term bonds
and shift the demand curve to the right.
• (3) Risk of Bonds Relative to Alternative Assets:

Øan increase in the riskiness of bonds causes the demand for bonds to fall and the
demand curve to shift to the left
Øan increase in the riskiness of alternative assets causes the demand for bonds to rise
and the demand curve to shift to the right.
• (4) Liquidity of Bonds Relative to Alternative Assets
Øincreased liquidity of bonds results in an increased demand for bonds, and
the demand curve shifts to the right
Øincreased liquidity of alternative assets lowers the demand for bonds shifts
the demand curve to the left
• (4.2) Shifts in the Supply of bonds
• (1) Expected Profitability of Investment Opportunities
Øin a business cycle expansion, the supply of bonds increases, and the supply
curve shifts to the right
Øin a recession, when there are fewer expected profitable investment
opportunities, the supply of bonds falls, and the supply curve shifts to the
left.
• (2) Expected Inflation
Øan increase in expected inflation causes the supply of bonds to increase and
the supply curve to shift to the right
• (3) Government Activities
Øhigher government deficits increase the supply of bonds and shift the supply
curve to the right
Øon the other hand, government surpluses decrease the supply of bonds and
shifts the supply curve to the left
(5) Changes in Expected Inflation: The Fisher Effect
- suppose expected inflation is initially 5% and initial ss and dd curves Bs

1
and Bs interested at point 1, where the equil. Bond price is P1 and equil.
1
interest rate is i 1,
- if expected inflation rises to 10% , the expected return on bonds relative to
real assets falls for any given bond price and interest rate.
- as a result, the dd for bonds falls, and the dd curve shifts to the left from Bd
1
to B d
2
- the rise in expected inflation also shifts the ss curve

- at any given bond price and interest rate, the real cost of borrowing has
declined, causing the quantity of bonds ss to increase, and the ss curve
shifts to the right from Bs to Bs
1 2
- when the dd and ss curves shift in response to the change in expected
inflation, the equil. moves from point 1 to point 2, the intersection of
Bd
and and Bs
2 2
- the equil. bond price has fallen fromP1 to P2, and because the bond price
is negatively related to the interest rate, the interest rate has risen from i 1,
to i 2
- equil. quantity of bonds could either rise or fall depending on the size of the
shifts in the ss and dd curves.
- when expected inflation rises, interest rates will rise
Ø this has been named the Fisher effect

Interest rate, i
Price of bonds, P
P increases i increases
Bs
1
Bs
1 2
P1 I1
P2 i2
Bd
1
Bd
2
Qty of Bonds, B
• (6) 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 at a given bond price and interest rate, the quantity of bonds
that firms want to sell (ss of bonds) will increase
- thus, ss curve will shift to the right from to
- expansion will also affect dd for bonds

- as the business cycle expands, wealth is likely to increase,
- thus dd for bonds will rise from Bd to Bd
1 2
- given that both the ss and dd curves have shifted to the right the new
equil. reached at the intersection of Bd and Bs must also move to
the right. 2 2
- depending on whether the ss curve shifts more than the dd curve or vice
versa, the new equil. interest rate can either rise or fall.
Price of bonds, P
P increases Interest rate, i
i increases
Bs
1
1 Bs
2
P1 i2
2
P2
i2
Bd
2
Bd
1
Qty of Bonds, B
(C) Supply and Demand in the Market for
Money: The Liquidity Preference Framework
• the previous analysis showed the determination of equilibrium interest rates using the
supply of and demand for bonds.
• it is also called the Loanable Funds Framework
• an alternative model, called the liquidity preference framework determines the
equilibrium interest rate in terms of the demand for and supply of money.
• Keynes assumed that there are 2 main categories of assets that people use to store
wealth: money and bonds
• Therefore, total wealth in the economy must equal total quantity of bonds plus money in
the economy.
• this equals quantity of bonds supplied (Bs) plus quantity of money supplied (Ms)
• the quantity of bonds (Bd) and money (Md) that people want to hold and thus demand
must also equal the total amount of wealth, because people cannot purchase more
assets than their available resources allow
• Thus, quantity of bonds and money supply must equal quantity of bonds and money
demand
• Bs + Ms = Bd + Md …………………………………(1)
• collecting bonds on 1 side and money on the other
• Bs - Bd = Md - Ms …………………………………(2)
• equation (2) tells us that if the market for money is in equilibrium (Ms =
Md), the RHS of eqn. (2) becomes zero, implying that Bs = Bd, meaning that
the bond market is also in equilibrium
• thus it is the same to think about determining the equilibrium interest rate
by equating the supply and demand for bonds or by equating the supply
and demand for money
• the reason that we approach the determination of interest rates with both
frameworks is that the loanable funds framework is easier to we when
analyzing the effects from changes in expected inflation, whereas the
liquidity preference framework provides a simpler analysis of the effects
from changes in income, the price level, and the supply of money.
FIGURE: EQUILIBRIUM IN THE MARKET FOR MONEY
Interest
rate, I (%)
A MS
A 25
20 B
15 C
10 A D
E
5
Md
100 200 300 400 500 600
Qty of Money, M
(N billions)
• money has a zero rate of return
• bonds, the only alternative asset to money have an expected return equal to the interest
rate i.
• as this interest rate rises, the expected return on money falls relative to the expected
return on bonds, and as the theory of asset demand tells us, this causes the demand for
money to fall.
• as the interest rate on bonds, i, rises, the opportunity cost of holding money rises, and so
money is less desirable and the quantity of money demanded must fall
• at point A, interest rate is 25% and quantity of bond demanded is N100 billion
• if interest rate is lower at 20%, opportunity cost of money is lower, and quantity of money
demanded rises to N200 billion
• as interest rate falls, quantity of money demanded rises, as indicated by points C, D, E
• we assume central bank controls the amount of money supply at a fixed quantity of N300
billion = vertical ss curve.
• Equilibrium where quantity of money demand and quantity of money supply occurs at
point C.
• Changes in Equilibrium Interest Rates in the Liquidity Preference
Framework
• (1) Shifts in the Demand for Money
• 2 factors cause the demand curve for money to shift: income and price
level
• (a) Income Effect
Øa higher level of income causes the demand for money to increase and the demand
curve to shift to the right.
• (b) Price-Level Effect
ØIncrease in price level means that the same nominal quantity of money no longer as
valuable. To restore their holdings of money in real terms, people will hold greater
nominal quantity of money
Øa rise in the price level causes the demand for money to increase and the demand
curve to shift to the right.
• (2) Shifts in the Supply of Money
• to keep it simple, we assume that money supply is controlled
completely by the central bank
• an increase in the money supply engineered by the central bank will
shift the supply curve for money to the right
A: Change in Income or Price Level
In a business cycle expansion,

Int. rate, i
Ms when income is rising, or when
the price level rises, dd curve
shifts from Md to Md
i2 1 2
Equil. interest rate rises from

i1 to i2
Md
i1
2
Md
1
M
Qty of Money, M
B: Change in Money Supply
when money ss , ss curve

Int. rate, i
shifts from Ms t to Ms
Ms Ms 1
1
1
2
Equil. interest rate falls from

i1 1 i1 to i2 .
2
i2
Md
Qty of Money, M
• ** Does an Increase in Money Supply always Lead to a fall in Interest rates?
• the liquidity preference analysis in above figure seems to lead to the conclusion
that an increase in the money supply will lower interest rates
• this has frequently caused politicians to call for a more rapid growth of the
money supply in order to drive down into rates.
• but is this conclusion correct?
• might there be other important factors left out of the liquidity preference analysis
that would reverse this conclusion?
• Milton Friedman – important criticism of this conclusion
Ø he acknowledges that the liquidity preference analysis is correct and calls the result (an
increase in money supply lowers interest rates) the LIQUIDITY EFFECT
Ø But, the liquidity effect might not be the only effect
Ø an increase in the money supply might not leave everything else equal and will have other
effects on the economy that may make interest rates rise.

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ECO 362 MODULE 5

where i = interest rate = yield to maturity

Price of Bonds, P (N)

100 200 300 400 500

Qty of Bonds (B)

• (3) Risk of Bonds Relative to Alternative Assets:

- suppose expected inflation is initially 5% and initial ss and dd curves Bs

- the rise in expected inflation also shifts the ss curve

Ø this has been named the Fisher effect

- expansion will also affect dd for bonds

100 200 300 400 500 600

In a business cycle expansion,

Equil. interest rate rises from

when money ss , ss curve

Equil. interest rate falls from

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