Group 2 - FNC02

Bùi Thị Mai Trâm

Nguyễn Phương Anh
Vũ Nguyễn Khánh Linh
Nguyễn Ngọc Thiện Đức
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CHAPTER 5: THE BEHAVIOR OF INTEREST RATES

1.DETERMINANTS OF ASSET DEMAND:

Wealth Expected Risk Liquidity

Return

Determinants The total The return The degree of The ease and
of Asset resources expected over uncertainty speed with
Demand owned by the the next period associated which an asset
individual, on one asset with the return can be turned
including all relative to on one asset into cash
assets. alternative relative to relative to
assets. alternative alternative
assets. assets.

Theory of The quantity The quantity The quantity The quantity

Asset Demand demanded of demanded of demanded of demanded of
an asset is an asset is an asset is an asset is
positively positively negatively positively
related to related to its related to the related to its
wealth expected risk of its liquidity
return relative returns relative to
to alternative relative to alternative
assets alternative assets
assets

2.CHANGES IN EQUILIBRIUM INTEREST RATES:

● The movement along the demand (supply) curve happens when the quantity of
demand (supply) changes;
● Bond’s price or interest rate: when one of these factors changes => demand
(supply) curve moves => a new equilibrium value for interest rates.
● The factors, which cause the demand curve for bonds to shift, include changes in
four parameters:
- Wealth
- Expected returns on bonds relative to alternative assets
- Risk of bonds relative to alternative assets
- Liquidity of bonds relative to alternative assets

Table 5-2 describes the effects of changes on the bond demand curve.

➔ Wealth:
- In a business cycle expansion with growing wealth, the demand for bonds
rises => the curve shifts to the right.
- In a recession, when income and wealth are falling, the demand for bonds falls
=> the curve shifts to the left.
➔ Expected returns:
- Higher expected interest rates in the future lower the expected return for long-
term bonds => decrease the demand => the curve shifts to the left.
- Lower expected interest rates in the future increase the demand for long-term
bonds => increase the demand => the curve shifts to the right.
➔ Risk:
 - An increase in the riskiness of bonds => demand for bonds falls =>the curve
shifts to the left.
- An increase in the riskiness of alternative assets => demand for bonds rises =>
the curve shifts to the right.
➔ Liquidity:
- Increased liquidity of bonds => demand for bonds increases =>the curve shifts
to the right.
- Increased liquidity of alternative assets => demand for bonds decreases => the
curve shifts to the left.

● The 3 factors cause the supply curve for bonds to shift :

1. Expected profitability of investment opportunities
2. Expected inflation
3. Government activities

Table 5-3 summarizes the effects of changes on the bond supply curve.

➔ Expected profitability of investment opportunities:

- In a business cycle expansion, the supply of bonds rises => the curve
shifts to the right.
- In a recession, the supply of bonds falls => the curve shifts to the left.

➔ Expected inflation:
 - An increase in expected inflation => supply of bonds rises =>the curve
shifts to the right.
- An decrease in expected inflation => supply of bonds falls =>the curve
shifts to the left.
➔ Government activities:
- Government deficits => the supply of bonds increases =>the curve
shifts to the right.
- Government surpluses => the supply of bonds decreases => the curve
shifts to the left.

● Remember that the interest rate is negatively related to the bond price

3. SUPPLY AND DEMAND IN THE MARKET FOR MONEY: THE LIQUIDITY

PREFERENCE FRAMEWORK

- A different model created by John Maynard Keynes, known as the liquidity

preference framework:
+ Derives the equilibrium interest rate in terms of the supply and demand for
money rather than using the supply and demand for bonds.
+ Analysis: Begins with the premise that money & bonds are the 2 main asset
classes that people utilize to keep their wealth.

- Total wealth in the economy:

- This equation can be modified by collecting the bond terms on one side and the

money terms on the other:

** If (the market for money) then (the bond market)

Equilibrium in the Market for Money: the

amount of money demanded at various intertest
rates, holding constant all orther economic factors:
- Point A: the amount of money requested is
$100 billion at a 25% interest rate
- Transfer from A to B: the interest rate ⇓
(20%) , the opportunity cost of money ⇓ &
the amount of money demanded ⇑ ($200
billion)
- Point C, D, E: the interest rate ⇓ & the
amount of money demanded ⇑
=> Only when the interest rate is at its equilibrium value will there be no tendency for it to
move further, and the interest rate will settle to its equilibrium value.

4. CHANGES IN EQUILIBRIUM INTEREST RATES

● Shifts in the demand for money
According to Keynes’s liquidity preference analysis, income and price-level can cause the
shift of the demand curve for money.
- Income effect: a higher level of income => demand for money at each interest rate⇑
the demand curve shifts to the right
- Price-level effect: price level increases => demand for money at each interest rate⇑
the demand curve shifts to the right

● Shifts in the supply for money

An increase in the money supply engineered by the Bank of Canada will make the supply
curve for money shift to the right.

● Money and interest rates

Price-level effect remains even after prices have stopped rising, while the expected-inflation
effect disappears.
Expected-inflation effect will continue as long as the price level keeps rising. A higher rate of
money supply growth will make a constantly rising price level, not a one-time increase in
money supply.
=> A higher rate of money supply growth is essential if the expected-inflation is to persist.

● Does a higher rate of growth of the money supply lower interest rates
- Liquidity preference: an increase in the money supply will lower interest rates.
- Income effect: increasing the money supply is an expansionary influence on the economy
=> interest rates rising (the demand curve shifts to the right).
- Price-Level effect: 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: an increase in the money supply may lead people to expect a
higher price level in the future => an increase in interest rates (the demand curve shifts to the
right).