Transcript Chapter 6

Chapter 6
Determining
Market
Interest Rates
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Views of Bond Market
We can view the buyer of bonds and the seller of
bonds in 2 ways:
1) The bond is the good: the lender is buying the
bond and the borrower is selling the bond. Price
= amount lender pays
2) Use of funds is the good: the borrower is
buying the use of funds and pays with a promise
to repay. Price = interest rate
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-2
Bond is the Good
Lender buys the bond
Borrower raising
funds
Borrower selling
bond
Lender supplying
funds
Bond price
Interest rate
Buyer
Seller
Use of Funds is the
Good
Price
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-3
Figure 6.1 Demand for Bonds
by Lenders
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-4
Figure 6.2 Supply of Bonds by
Borrowers
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-5
Figure 6.3 Equilibrium in Markets for
Bonds and Loanable Funds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-6
Explaining Changes
in Equilibrium Interest Rates
• Changes in bond demand or supply will change
the bond price and interest rate.
• Theory of portfolio allocation can explain bond
demand curve shifts.
• Changes in willingness and ability to borrow
shifts the supply curve.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-7
Figure 6.4 Shifts in the
Demand for Bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-8
Factors Shifting Increasing
Bond Demand
•
•
•
•
•
•
•
Higher wealth
Higher expected returns on bonds
Lower expected inflation
Lower expected return on other assets
Lower relative riskiness of bonds
Higher relative liquidity of bonds
Lower relative information costs of bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-9
Factors Increasing Bond
Supply
•
•
•
•
Higher expected profitability of capital
Lower business taxes
Lower expected inflation
Higher government borrowing
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-10
Figure 6.5 Shifts in the Supply
of Bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-11
Figure 6.6 Interest Rate Changes
in an Economic Downturn
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-12
Figure 6.7 Expected Inflation
and Interest Rates
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-13
The International Capital Market
and the Interest Rate
• Closed Economy: an economy that neither borrows
nor lends to foreign countries
• Open Economy: capital is mobile internationally
• World real interest rate (rw): the interest rate that is
determined in the international capital market
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-14
Figure 6.8 Flow of Funds in an
Open Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-15
Open Economies
• Small open economy: the quantity of loanable
funds supplied is too small to affect the world
interest rate and the economy takes rw as given
• Large open economy: an economy that is large
enough to affect the world interest rate
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-16
Figure 6.9 Determining the Real
Interest Rate in a Small Open Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-17
Figure 6.10 Determining the Real
Interest Rate in a Large Open Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-18
Table 6.1 Factors That Shift
the Demand Curve for Bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-19
Table 6.2 Factors That Shift
the Supply Curve for Bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-20