Loanable funds Chapter 2 note

Govt demand for loanable funds ( note

khata)
Foreign demand for loanable funds

Imagine you are saving money to buy a

house. You might consider different banks
to put your money in (loanable funds
market). The bank with the higher interest
rate (better return on your savings) is
more attractive, right?

This is just like how countries decide

where to park their extra money (loanable
funds). They will lend it to the country
with the higher interest rate (like getting a
better savings deal). This flow of money
between countries affects how much
money is available for borrowing in each
country's loanable funds market.

Imagine a country is like a person

needing to borrow money. The interest rate is like the cost of borrowing. They will borrow more
from the friend (foreign country) with the lower interest rate. The bigger the difference in interest
rates, the more they will borrow from the cheaper friend.

what is the relationship between interest rate and quantity of demand in case
of foreigndemand for loanable fund, when the demand curve will move to the
right, when the demand curve move to the left

The relationship between interest rates and the quantity of loanable funds demanded by
foreign countries is also inversely proportional. Here's why:

Lower Interest Rates in the U.S. (Compared to Foreign Rates):

 When interest rates in the U.S. are lower compared to their own country's rates,
borrowing from the U.S. becomes more attractive for foreign governments and
corporations. This is because they can get a better deal on loans (pay less interest).
This leads to an increase in the quantity of loanable funds demanded by foreign
entities.
 They might borrow more to finance government projects, invest in U.S. businesses, or
simply park their extra cash in U.S. investments that offer a higher return (interest)
compared to their home country.

Higher Interest Rates in the U.S. (Compared to Foreign Rates):

 When interest rates in the U.S. are higher compared to their own country's rates,
borrowing from the U.S. becomes less attractive for foreign entities. They can
find cheaper loans elsewhere. This leads to a decrease in the quantity of loanable
funds demanded by foreign entities.
 They might look to borrow from other countries with lower interest rates or choose to
invest their funds domestically.

Shifting the Demand Curve for Foreign Loanable Funds:

 Rightward Shift (Increased Demand): This can happen due to factors beyond just
U.S. interest rates. Here are some examples:
o Strong U.S. Economy: A stable and growing U.S. economy can be seen as a safer
place to invest, attracting foreign capital.
o Political Instability Abroad: If a foreign country experiences political or economic
turmoil, investors might seek safer havens for their money, like the U.S. loanable funds
market.
o Currency Exchange Rates: Favorable exchange rates can make U.S. investments
even more attractive for foreign entities.
 Leftward Shift (Decreased Demand): This can occur due to factors other than U.S.
interest rates as well:
o Economic Growth Abroad: If foreign countries experience strong economic growth
themselves, they might have less need to borrow from the U.S. and might even attract
foreign investment themself.
o Stricter Regulations in the U.S.: If the U.S. imposes stricter regulations on foreign
investment, it could discourage foreign entities from borrowing or investing in the U.S.
loanable funds market.

Key Takeaway: The interest rate differential between the U.S. and foreign countries is
a major driver of foreign demand for loanable funds. However, other economic and
political factors can also play a role in shifting the demand curve.

• A country’s demand for foreign funds depends on the interest rate differential between the two.
• the cost of
• The greater the differential, the greater the demand for foreign funds.
borrowing in the U.S. (interest rate) affects how much foreign
governments want to borrow from the U.S. (demand for loanable
funds). Lower cost (interest rate) leads to higher demand, and
 higher cost leads to lower demand. This relationship is inverse
because they move in opposite directions.

 Lower U.S. interest rates act like a sale on borrowing. It's cheaper
for foreign governments to borrow from the U.S. So, they tend to
borrow more from the U.S. loanable funds pool.
 Higher U.S. interest rates are like borrowing becoming
more expensive. Foreign governments might look elsewhere for
cheaper loans, reducing their demand for U.S. loanable funds.

Aggregate demand for loanable fund:

Income- Expenditure= Saving..Saving baranor jonno income barate hobe
expenditure komate hobe.Saving create korte time lage.
• The sum of the quantities demanded by the separate sectors at any given interest rate.

Sab

 the total demand for loanable funds goes down when interest rates go up, and vice versa. It's like
a seesaw - one goes up, the other goes down. Lower interest rates make borrowing cheaper.
This incentives all sectors (businesses, governments, households, foreigners) to borrow more,
leading to a higher aggregate demand for loanable funds.
 Higher interest rates make borrowing more expensive. This discourages all sectors from
borrowing as much, resulting in a lower aggregate demand for loanable funds.
 If the demand schedule of any sector changes, it affects the aggregate demand for loanable
funds. Let's see how:

 Increased demand from one sector (e.g., businesses): If businesses suddenly need to borrow a
lot more money (their demand for loans increases), it reduces the pool of funds available for
others (households, governments). This pushes the aggregate demand curve up because the
total borrowing need across all sectors has gone up.
 Decreased demand from one sector (e.g., households): If households decide to save more and
borrow less (their demand for loans decreases), it frees up loanable funds for others. This pushes
the aggregate demand curve down because the total borrowing need across all sectors has gone
down.

In essence, changes in the borrowing needs of any individual sector can ripple through the entire
loanable funds market, affecting the overall demand for loans.

Household demand for loanable fund:

households are part of the loanable funds market. They borrow money to finance things
they need or want, like:

 Housing: Buying a house often requires a loan (mortgage) because it's a large
expense.
 Vehicles: Cars and other vehicles can be expensive, so people might take out loans to
purchase them.
 Household items: This could include anything from furniture and appliances to
electronics and even home improvements. Loans can help spread out the cost of these
items over time.

Interest rates impact how much households borrow:

 This point highlights the relationship between interest rates and borrowing by
households. It's an inverse relationship, meaning:
o Lower interest rates: When borrowing costs less (lower interest rates),
households are generally more likely to take out loans. This means the quantity
of loanable funds demanded by households increases.
o Higher interest rates: When borrowing costs more (higher interest rates),
households might be discouraged from borrowing or borrow less. This means
the quantity of loanable funds demanded by households decreases
 o

what is the relationship between interest rate and

quantity of demand in case of Household demand for
loanable fund, when the demand curve will move to
the right, when the demand curve move to the left

The relationship between interest rates and the quantity of loanable funds
demanded by households is also inversely proportional. Here's how it works:

Lower Interest Rates:

 When interest rates decrease, borrowing becomes cheaper. This makes households
more likely to take out loans for various needs, leading to an increase in the quantity
of loanable funds demanded.
 Examples: Borrowing more for a mortgage (buying a house), financing a car purchase,
or consolidating existing debts at a lower interest rate.

Higher Interest Rates:

 When interest rates increase, borrowing becomes more expensive. This discourages
households from taking out loans or they might borrow less. This translates to
a decrease in the quantity of loanable funds demanded.
 Households might choose to delay purchases like cars or renovations, or prioritize
saving over borrowing.
 Shifting the Demand Curve:

 Rightward Shift (Increased Demand): This happens when factors besides interest
rates make borrowing more attractive for households. Examples include:
o Increased Income: If households have more disposable income, they might be more
comfortable taking on debt.
o Consumer Confidence: A strong economy and positive consumer sentiment can
encourage borrowing for major purchases.
o Expected Price Increases: If households believe prices of desired goods (like houses)
will rise in the future, they might borrow to purchase them now.
 Leftward Shift (Decreased Demand): This happens when factors besides interest
rates make borrowing less attractive or discourage spending. Examples include:
o Decreased Income: If households face financial difficulties, they might cut back on
borrowing.
o Economic Uncertainty: Job insecurity or fears of a recession can lead households to
be more cautious with borrowing.
o High Debt Levels: Households with existing high debt might be less likely to take on
additional loans.

Remember: While interest rates are a major influence, other factors can also shift the
household demand curve for loanable funds. These factors affect households' overall
willingness to borrow and their perceived ability to repay loans.

Business demand for loanable funds• Depends on number of business projects to implemented.
• More demand at lower interest rates.
 how the interest rate affects business demand:

 Lower interest rates: When interest rates are low, borrowing becomes cheaper for
businesses. This encourages them to borrow more, shifting the demand curve to the
right. Lower interest rates make projects with a lower potential return on investment
more feasible.
 Higher interest rates: When interest rates are high, borrowing becomes more
expensive. This discourages businesses from borrowing heavily, shifting the demand
curve to the left. Only projects with a high potential return on investment become
attractive at higher interest rates.

Additional factors can also influence business demand for loanable funds:

 Economic conditions: A strong and growing economy typically leads to increased

business borrowing, as companies are more optimistic about future profits. Conversely,
a weak economy might lead to decreased borrowing due to lower confidence and
potential risks.
 Business profitability: Companies with a strong track record of profitability and
positive cash flow are more likely to qualify for loans and have a higher demand for
them.
 Availability of credit: The overall availability of credit in the market also impacts
business borrowing. During financial crises, banks may become more cautious in
lending, limiting the access to loanable funds for businesses.

Understanding the factors affecting business demand for loanable funds is crucial for
various stakeholders, including:

 Policymakers: They can use monetary policy tools like interest rates to influence
business investment and economic activity.
 Lenders: They can assess the risk associated with lending to businesses and set
appropriate interest rates.
 Businesses: They can make informed decisions about borrowing and investment
based on the prevailing interest rates and economic conditions.
 what is the relationship between interest rate and
quantity of demand in case of business loanable
fund , when the demand curve will move to the
right, when the demand curve move to the left
The relationship between interest rates and the quantity of loanable funds demanded iin
case of business loanable funds inversely proportional. This means they move in
opposite directions:

 Lower interest rates: When borrowing costs decrease, the quantity of loanable
funds demanded increases. Businesses are more likely to borrow for investments as
 the cost of borrowing is cheaper. Households might also borrow more for things like
houses or cars. This movement is shown by the demand curve shifting to the right.
 Higher interest rates: When borrowing costs increase, the quantity of loanable
factors demanded decreases. Businesses might reconsider investments due to higher
costs, and households might be discouraged from borrowing. This movement is shown
by the demand curve shifting to the left.

Here's when the demand curve might shift to the right (increase in quantity
demanded):

 Economic boom: Increased business confidence and growth prospects lead to higher
demand for investment funds.
 Technological advancements: Exciting new technologies might create attractive
investment opportunities, prompting businesses to borrow more.
 Government incentives: Policies like tax breaks for investment can encourage
businesses to borrow and invest.

Here's when the demand curve might shift to the left (decrease in quantity
demanded):

 Economic recession: Businesses become cautious and borrow less due to lower sales
or uncertainty.
 Increased regulation: Stricter regulations on businesses can make borrowing less
attractive or more expensive.
 Political instability: Uncertainty about the future can discourage businesses from
borrowing for long-term investments.

Remember, the interest rate itself is a major factor that influences the position of the
demand curve. However, these other factors can also play a role by affecting the overall
desire of businesses and households to borrow money.

what is the relationship between interest rate and

quantity of demand in case of governmenr demand for
loanable fund, when the demand curve will move to
the right, when the demand curve move to the left

The relationship between interest rates and the quantity of loanable funds demanded by
the government is a bit different compared to households and businesses. Here's the
breakdown:

Interest Rates and Government Demand:

 Unlike households and businesses, the government's demand for loanable funds
(through issuing bonds) is generally considered less sensitive to interest rates.
 This means that even if interest rates increase (borrowing becomes more expensive),
the government might still need to borrow a similar amount to finance its planned
spending if tax revenue isn't enough. They might have to prioritize essential projects
even with higher borrowing costs.

The relationship between interest rates and the quantity of loanable funds demanded by
the government is a bit different compared to households and businesses. Here's the
breakdown:

Interest Rates and Government Demand:

 Unlike households and businesses, the government's demand for loanable funds
(through issuing bonds) is generally considered less sensitive to interest rates.
 This means that even if interest rates increase (borrowing becomes more expensive),
the government might still need to borrow a similar amount to finance its planned
spending if tax revenue isn't enough. They might have to prioritize essential projects
even with higher borrowing costs.

Shifting the Government Demand Curve:

However, there can still be situations where the government's demand curve for
loanable funds shifts based on factors besides interest rates:

 Rightward Shift (Increased Demand): This can happen due to:

o Increased Spending: If the government plans to spend more on infrastructure projects,
social programs, or national defense, it will need to borrow more funds, shifting the
demand curve right. This could be due to emergencies, economic downturns, or new
initiatives.
o Tax Cuts: If the government cuts taxes, it will likely need to borrow more to maintain==
its spending levels, pushing the demand curve right.
 Leftward Shift (Decreased Demand): This can happen due to:
o Budget Surplus: If the government collects more tax revenue than it spends, it might
need to borrow less, shifting the demand curve left.
o Spending Cuts: If the government implements spending cuts in response to economic
pressure or a desire to reduce debt, it will need to borrow less, shifting the demand
curve left.

Remember: While interest rates play a less significant role for government borrowing compared
to households and businesses, the overall level of government spending and tax revenue are
the main factors that can shift the demand curve for loanable funds.

Supply of Loanable funds

 The equilibrium point between interest rate and quantity of loanable funds is the sweet
spot where the demand for loanable funds equals the supply of loanable funds in the
market. Imagine it's a marketplace where lenders (suppliers) offer money at a certain
interest rate, and borrowers (demanders) look for loans at a specific cost (interest rate).

Here's how it works:

 Interest Rate: This acts as the price of borrowing money. A higher interest rate means
borrowing is more expensive, and a lower interest rate means it's cheaper.
 Quantity of Loanable Funds: This refers to the total amount of money that lenders
are willing to supply and borrowers are willing to demand at a specific interest rate.

Finding the Balance:

The equilibrium point is found where the demand curve (representing how much
borrowers want at different interest rates) intersects the supply curve (representing
how much lenders are willing to supply at different interest rates).

 Above the Equilibrium: If the interest rate is higher than the equilibrium point, the
quantity of loanable funds demanded by borrowers will be less than the quantity
supplied by lenders. This creates a surplus of loanable funds. In a competitive market,
lenders will likely lower the interest rate to attract more borrowers, pushing the market
towards equilibrium.
 Below the Equilibrium: If the interest rate is lower than the equilibrium point, the
quantity of loanable funds demanded by borrowers will be higher than the quantity
supplied by lenders. This creates a shortage of loanable funds. In response, lenders
 will likely raise the interest rate to ration the limited funds and discourage excessive
borrowing, again moving towards equilibrium.

Why is Equilibrium Important?

The equilibrium point determines the market interest rate and the total amount of
borrowing that takes place. It affects businesses, households, and the government in
their borrowing decisions. A healthy loanable funds market with a stable equilibrium
point is crucial for economic growth and investment.

Factors Affecting Interest Rates

Impact of economic growth on interest rates

Here's a breakdown of when the loanable funds demand curve will move left (decrease)
and right (increase) based on economic growth and other factors:

Demand Curve Moves Right (Increased Demand):

 Economic Growth: As explained earlier, strong economic growth can lead businesses
to be more optimistic and borrow more for expansion, shifting the demand curve right.
This is because businesses have more investment opportunities and feel confident
about the future.
 Decreased Interest Rates: When borrowing becomes cheaper due to lower interest
rates, it incentivizes businesses and households to borrow more. This leads to
a rightward shift in the demand curve for loanable funds.
 Increased Income and Consumer Confidence: Rising incomes and a positive
economic outlook can make households more comfortable taking on debt for
mortgages, cars, or other purchases. This pushes the demand curve for loanable
funds right, though the shift might be smaller compared to businesses.
 Favorable Government Policies: Government policies like tax breaks for investment
or subsidies for specific industries can encourage borrowing and investment, shifting the
demand curve right.

Demand Curve Moves Left (Decreased Demand):

 Economic Downturn: During recessions or economic downturns, businesses become

cautious and borrow less due to lower sales or uncertainty. This leads to a leftward
shift in the demand curve for loanable funds.
 Increased Interest Rates: When borrowing becomes more expensive due to higher
interest rates, businesses and households might reconsider investments or borrowing
plans. This discourages borrowing and shifts the demand curve for loanable funds left.
 Decreased Income and Consumer Confidence: If households experience falling
incomes or economic anxieties, they might be more likely to save and borrow less. This
pushes the demand curve for loanable funds left.
 Political Instability or Uncertainty: Political instability or a perceived lack of economic
security can discourage borrowing and investment, shifting the demand curve for
loanable funds left.

Impact of inflation on interest rates

mpact of Inflation on Interest Rates and Loanable

Funds Market
Inflation, the rise in general price levels, can have complex effects on interest rates and
the loanable funds market. Here's a breakdown:

Impact on Interest Rates:

 Expected Inflation: If inflation is expected to rise, central banks might raise interest
rates proactively to curb inflation before it gets out of hand. This discourages borrowing
and spending, helping to cool down the economy and stabilize prices. (Interest rates
rise)
 Unexpected Inflation: If inflation is unexpectedly high, lenders might demand higher
interest rates to compensate for the erosion of the purchasing power of their loans.
(Interest rates rise)

Impact on Loanable Funds Demand:

 Uncertainties: High or unexpected inflation can create uncertainty about future

economic conditions. This might lead to:
o Businesses: Businesses might postpone borrowing and investment due to uncertainty,
causing the demand curve for loanable funds to shift left.
o Households: Households might become cautious about borrowing for big purchases
due to rising prices, also causing the demand curve to shift left (though the effect might
be smaller).

Impact of Inflation on Interest Rates and Loanable

Funds Market
Inflation, the rise in general price levels, can have complex effects on interest rates and
the loanable funds market. Here's a breakdown:

Impact on Interest Rates:

 Expected Inflation: If inflation is expected to rise, central banks might raise interest
rates proactively to curb inflation before it gets out of hand. This discourages borrowing
and spending, helping to cool down the economy and stabilize prices. (Interest rates
rise)
 Unexpected Inflation: If inflation is unexpectedly high, lenders might demand higher
interest rates to compensate for the erosion of the purchasing power of their loans.
(Interest rates rise)

Impact on Loanable Funds Demand:

 Uncertainties: High or unexpected inflation can create uncertainty about future

economic conditions. This might lead to:
o Businesses: Businesses might postpone borrowing and investment due to uncertainty,
causing the demand curve for loanable funds to shift left.
o Households: Households might become cautious about borrowing for big purchases
due to rising prices, also causing the demand curve to shift left (though the effect might
be smaller).

Impact on Loanable Funds Supply:

 Inflation and Savers: If inflation is high, the real return on savings (interest rate minus
inflation) might be negative. This discourages saving and could potentially decrease
the supply of loanable funds (supply curve shifts left). However, some savers might
be motivated to save more to keep up with inflation, leading to an uncertain impact on
the supply curve.

Equilibrium Point:

 The combined effects of these factors can influence the equilibrium point in the loanable
funds market. It depends on the specific situation:
o Central Bank Response: If the central bank raises interest rates in response to
inflation, it could lead to a higher equilibrium interest rate and a lower equilibrium
quantity of loanable funds borrowed.
o Uncertainty and Savings: If inflation creates significant uncertainty and discourages
saving, it could lead to a lower equilibrium quantity of loanable funds even if the
interest rate remains the same.

Demand Curve Shifts:

Here's a summary of when the demand and supply curves might shift due to inflation:

 Demand Curve Moves Right (Increased Demand): Not very likely due to inflation
itself. However, it could happen if inflation leads to:
o Expectation of Higher Profits: Businesses might anticipate higher future profits due to
inflation and borrow more to invest (unlikely scenario).
 Demand Curve Moves Left (Decreased Demand): More likely due to inflation:
o Uncertainty: High or unexpected inflation can cause businesses and households to
borrow less (demand curve shifts left).
 Supply Curve Moves Right (Increased Supply): Not very likely due to inflation.
Savers might actually be incentivized to save more to keep up with inflation, but the
overall impact is uncertain.
 Supply Curve Moves Left (Decreased Supply): Possible due to inflation:
o Negative Real Returns: If inflation is high and erodes the purchasing power of savings,
people might save less, reducing the supply of loanable funds (supply curve shifts left).

Finding the Equilibrium:

The exact equilibrium point depends on the interplay of these factors and the central
bank's response. There's no single answer as the impact of inflation can be complex

Impact of inflation on interest rates

• Fisher proposed that nominal interest payments compensate savers in
two
ways.
o First, they compensate for a saver’s reduced purchasing power.
o Second, they provide an additional premium to savers for forgoing
present consumption.
• Fisher effect: i = E(INF) + iR
where, i = nominal or quoted rate of interest
E(INF) = expected inflation rate

iR = real interest rate

 Impact of monetary policy on interest rate:
By controlling the flow of marbles (money) into the jar (loanable funds market),
the BB can influence the price of borrowing marbles (interest rates) in the
economy. This affects how much businesses, households, and the government can
borrow.

The crowding out effect is an economic theory that suggests that increased
government spending can lead to higher interest rates and reduced private sector
investment. Here's a breakdown:

When the Government Spends More:

 The government finances its spending through a few methods, like raising taxes or
borrowing money by selling bonds.
 When the government borrows more, it competes with businesses and households for a
limited pool of loanable funds in the market.

Impact on Interest Rates:

 This increased demand for funds by the government can push interest rates up. Think
of it like an auction - with more participants (government) vying for the same funds,
lenders might raise the price (interest rate) to compensate for the higher demand.

Impact on Private Sector Borrowing:

 Higher interest rates make borrowing more expensive for businesses and households.
This discourages them from taking out loans for investments, home purchases, cars,
etc.
 In essence, the government's increased borrowing "crowds out" some of the private
sector's borrowing activity.

Consequences: Less capital accumulation, slower economic growth.

 Reduced private sector investment can potentially slow down economic growth in the
long run. This is because businesses might invest less in new equipment, technology,
or expansion plans if borrowing is expensive.


Not Always Straightforward:

 The crowding out effect isn't always a given. It depends on various factors like the size
of the government's borrowing compared to the overall loanable funds market and the
state of the economy.
 During economic downturns, private sector borrowing might be low anyway. In such
situations, government spending can actually stimulate the economy by creating
demand and jobs, even if it crowds out some private investment.

Key Takeaway:

The crowding out effect highlights a potential trade-off between government spending
and private sector investment. While increased government spending can address
certain needs, it's important to consider its potential impact on borrowing costs and
economic growth.

•Net Demand for funds (ND) should be forecast: ND = DA– SA ND = (Dh + Db +

D,m + Dr) – (Sh + Sb + Sm + Sf) • If the forecasted level of ND is positive or
negative, then a disequilibrium will exist temporarily. • If ND is positive, the
disequilibrium will be corrected by an upward adjustment in interest rates; if
ND is negative, the disequilibrium will be corrected by a downward
adjustment. • The larger the forecasted magnitude of ND, the larger the
adjustment in interest rates.
 Drive er math gula dekhte hobe

Chapter 3
Structure of Interest rates
Why debt security yields vary-
Several factors influence the yields of debt securities, including:

1. Credit (default) risk: This refers to the possibility of the issuer defaulting
on their debt obligation, meaning they fail to make the promised interest
payments or repay the principal amount at maturity. As a general rule, higher credit
risk translates to higher yields. Investors demand a higher return for taking on the
increased risk of default. For instance, a corporate bond issued by a company with a
low credit rating (indicating a higher default risk) will offer a higher yield compared to a
bond issued by a company with a high credit rating (indicating a lower default risk).

You lend money to two friends.Your close friend, who always pays you back on time,
might only owe you a small amount of interest.Your friend who sometimes forgets to
pay you back on time might owe you a higher amount of interest to make up for the
risk.

The concept applies the same way to debt securities and credit risk.

Investors are risk-averse. They don't like the idea of losing their money. So, when they
invest in a debt security, they want to be compensated for the possibility that the issuer
might not pay them back.

Here's a breakdown to make it clearer:

 Imagine two companies: Company A is very stable and financially strong, while
Company B is a newer startup with a higher chance of failing.
 Both companies issue bonds. Bonds are essentially loans you make to a company,
and in return, they promise to pay you interest and return your principal amount at
maturity.
 Company A's bonds will have a lower yield. Investors are confident they'll get their
money back, so they're happy with a smaller return.
 Company B's bonds will have a higher yield. Investors are taking on more risk by
lending to a less stable company. To convince them to invest, Company B has to offer a
higher potential return.

Think of yield as a kind of insurance premium. The riskier the investment (higher
chance of default), the higher the premium (yield) you demand to compensate for that
risk

2. Term to maturity: This refers to the length of time until the debt security matures and the
investor receives their principal back. Generally, longer-term debt securities offer higher
yields than shorter-term ones. This compensates investors for tying up their capital for a
longer period. For example, a 10-year government bond will typically have a higher yield than a
2-year government bond.

3. Liquidity:Liquidity means how easily an asset can be exchanged. It means how quickly we
can get money out of an asset. Less liquid securities tend to offer higher yields as investors
require compensation for the potential difficulty of selling them quickly if needed. For
example, a corporate bond traded on a less active exchange might offer a higher yield
compared to a similar bond traded on a major exchange.
4. Tax status: The tax implications of a debt security can also affect its yield. Tax-exempt
securities, which do not generate taxable interest income, typically offer lower yields than
taxable For example, municipal bonds issued by local governments are often exempt from
securities because investors are willing to accept a lower return in exchange for the tax
benefits. federal income tax, and therefore, they generally offer lower yields than corporate
bonds.

Investors are more concerned with after-tax income

o Taxable securities must offer a higher before-tax yield
o The extra compensation required on taxable securities depends on

the tax rates of individual and institutional investors.

These are some of the key factors that contribute to the variations in yields among debt
securities. By understanding these factors, investors can make more informed decisions when
selecting debt securities for their portfolio

Pure expectation theory (Inpact of a sudden expectation of higher interest rates)

 The three graphs in the image are visualizations of yield curves, which depict the
relationship between the interest rate and the length of time until a bond matures
https://en.wikipedia.org/wiki/Yield_curve. The x-axis represents the term to maturity,
which is the time until the bond pays out to the investor. The y-axis represents the yield,
which is the interest rate that the bond offers.

The first graph (Panel A) is titled "Impact of Expected Higher Interest Rates." It shows
a yield curve that slopes upwards. This means that long-term bonds are offering higher
interest rates than short-term bonds. This can happen because investors expect interest
rates to rise in the future. They are willing to lend money for a longer period of time only
if they are compensated with a higher interest rate.

The second graph (Panel B) is titled "Impact of Expected Lower Interest Rates." It
shows a yield curve that slopes downwards. This means that short-term bonds are
offering higher interest rates than long-term bonds. This can happen because investors
expect interest rates to fall in the future. They are more willing to lend money for a
shorter period of time, rather than lock their money into a long-term bond that may offer
a lower interest rate in the future.

The third graph (not labeled) shows a flat yield curve. This means that all bonds,
regardless of their maturity, are offering the same interest rate. This can happen
because investors are uncertain about the future direction of interest rates.

Impact of sudden expectation of lower interest rates:

The three
graphs depict
yield curves,
which show
this
relationship
between
interest rate
and the time to
maturity. The
x-axis
represents the
term to
maturity, which
is the time until
the bond
matures. The
y-axis represents the yield, which is the interest rate that the bond offers.

 The first graph (Panel A) is titled "Impact of a Sudden Expectation of Lower Interest
Rates." It shows a yield curve that slopes downwards. This means that short-term
 bonds are offering higher interest rates than long-term bonds. This can happen because
investors expect interest rates to fall in the future. They are more willing to lend money
for a shorter period of time, rather than lock their money into a long-term bond that may
offer a lower interest rate in the future.

 The second graph (Panel B) is titled "Impact of a Sudden Expectation of Higher Interest
Rates." It shows a yield curve that slopes upwards. This means that long-term bonds
are offering higher interest rates than short-term bonds. This can happen because
investors expect interest rates to rise in the future. They are willing to lend money for a
longer period of time only if they are compensated with a higher interest rate.

 The third graph (not labeled) shows a flat yield curve. This means that all bonds,
regardless of their maturity, are offering the same interest rate. This can happen
because investors are uncertain about the future direction of interest rates.\

Pure expectations theory, also known as the unbiased expectations theory, is a

financial theory that explains how investors' expectations about future interest rates
influence the current yield curve.
 The graph shows three scenarios with different expectations for future interest
rates. The scenarios are:

 Stable interest rates

 Increasing interest rates
 Decreasing interest rates
 The y-axis of the graph shows the annualized yield, and the x-axis shows the term to
maturity. The term to maturity is the length of time until the bond matures.

In all three scenarios, the yield increases as the term to maturity increases. This is
because long-term bonds are generally less liquid than short-term bonds, and investors
require a higher return to compensate for this lower liquidity.

The graph also shows that the size of the liquidity premium changes depending on the
expectations for future interest rates.

 In the scenario with stable interest rates, the liquidity premium is relatively small. This is
because investors are not very concerned about the risk of interest rates changing.
 In the scenario with increasing interest rates, the liquidity premium is larger. This is
because investors are concerned that if they invest in long-term bonds, they will be
stuck with a low interest rate if interest rates rise.
 In the scenario with decreasing interest rates, the liquidity premium is also larger. This is
because investors are concerned that if they invest in short-term bonds, they will miss
out on higher interest rates in the future.

The takeaway from the liquidity premium theory is that investors consider both the
liquidity of an investment and the expected future path of interest rates when making
investment decisions.
Investors prefer short-term liquid securities but will be willing to
invest in long-term securities if compensated with a premium for
lower liquidity.
 The y-axis of
the graph
shows the
annualized
yield, and
the x-axis
shows the
term to
maturity. The
term to
maturity is
the length of
time until the
bond
matures.
 In all three
scenarios,
the yield
increases as
the term to
maturity
 increases. This is because long-term bonds are generally less liquid than short-term
bonds, and investors require a higher return to compensate for this lower liquidity.
 The graph also shows that the size of the liquidity premium changes depending on the
expectations for future interest rates. Here are the specific scenarios:
o Stable interest rates: the liquidity premium is relatively small. This is because investors
are not very concerned about the risk of interest rates changing.
o Increasing interest rates: the liquidity premium is larger. This is because investors are
concerned that if they invest in long-term bonds, they will be stuck with a low interest
rate if interest rates rise.
o Decreasing interest rates: the liquidity premium is also larger. This is because investors
are concerned that if they invest in short-term bonds, they will miss out on higher
interest rates in the future.

The takeaway from the liquidity premium theory is that investors consider both the
liquidity of an investment and the expected future path of interest rates when making
investment decisions.
Exercise 1,2,3,4,5,6,7 khatay kora