Transcript Chpt #5

Chapter 5
The Behaviour of
Interest Rates
5.1
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Determining the
Quantity Demanded of an Asset
• Wealth - the total resources owned by the
individual, including all assets
• Expected Return - the return expected over the
next period on one asset relative to alternative
assets
• Risk - the degree of uncertainty associated with the
return on one asset relative to alternative assets
• Liquidity - the ease and speed with which an asset
can be turned into cash relative to alternative
assets
5.2
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Theory of Asset Demand
Holding all 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.
5.3
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Theory of Asset Demand
(Cont’d)
5.4
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Supply and Demand
for Bonds
• At lower prices (higher interest rates), ceteris
paribus, the quantity demanded of bonds is
higher—an inverse relationship.
• At lower prices (higher interest rates), ceteris
paribus, the quantity supplied of bonds is
lower—a positive relationship.
5.5
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Supply and Demand for
Bonds (Cont’d)
5.6
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Derivation of Bond
Demand Curve
i= RETe =(F- P)/P
Point A: Figure 5-1
P = $950
i= ($1000-$950)/$950 = 0.053 = 5.3%
d
B = $100 billion
5.7
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Market Equilibrium
• Occurs when the amount that people are willing to
buy (demand) equals the amount
that people are willing to sell (supply) at a given
price.
• When Bd = Bs  the equilibrium (or market
clearing) price and interest rate
• When Bd > Bs  ‘excess demand’  price will rise
and interest rate will fall
• When Bd < Bs  ‘excess supply’  price will
fall and interest rate will rise
5.8
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• See overheads that convert this supply
and demand for bonds into a loanable
funds framework that allows us to relate
the workings of the bond market to the
monetary sector of the economy.
5.9
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Shifts in the Demand for
Bonds
• Wealth - in an expansion with growing wealth, the demand
curve for bonds shifts to the right
• Expected Returns - higher expected interest rates in the
future lower the expected return for long-term bonds,
shifting the demand curve to the left
• Expected Inflation - an increase in the expected rate of
inflations lowers the expected return for bonds, causing the
demand curve to shift to the left
• Risk - an increase in the riskiness of bonds causes the
demand curve to shift to the left
• Liquidity - increased liquidity of bonds results in the
demand curve shifting right
5.10
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Shifts in the Demand for
Bonds (Cont’d)
5.11
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Shifts in the Demand for
Bonds (Cont’d)
5.12
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Shifts in the Supply of
Bonds
• Expected profitability of investment
opportunities - in an expansion, the supply
curve shifts to the right
• Expected inflation - an increase in expected
inflation shifts the supply curve for bonds to
the right
• Government activities - increased budget
deficits/surpluses shift the supply curve to
the right/left
5.13
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Shifts in the Supply of
Bonds (Cont’d)
5.14
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Response to a Change in
Expected Inflation
5.15
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Expected Inflation and
Interest Rates
5.16
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Response to a Business
Cycle Expansion
5.17
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Business Cycles and
Interest Rates
5.18
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• Review of the monetary sector that macro
economists call the ‘money market’
because it looks at the demand and
supply for money balances (i.e. M1 or M2)
5.19
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Response to a Lower
Savings Rate
5.20
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The Liquidity Preference
Framework
Keynesian model that determines the equilibrium interest rate
in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs  M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).
5.21
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• Can also be explained in terms of the
loanable funds framework that relates
total loanable funds to the interest rates
or yields to maturity for debt instruments
5.22
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The Liquidity Preference
Framework (Cont’d)
5.23
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Shifts in the Demand
for Money
• Income Effect - a higher level of income
causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
• Price-Level Effect - a rise in the price level
causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
5.24
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Shifts in the Supply
of Money
• Assume that the supply of money is
controlled by the central bank.
• An increase in the money supply
engineered by the Bank of Canada
will shift the supply curve for money to
the right.
5.25
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Shifts in the Demand
and Supply of Money
5.26
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Shifts in the Demand and
Supply of Money (Cont’d)
5.27
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Shifts in the Demand and
Supply of Money (Cont’d)
5.28
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Money and Interest Rates
• Income effect of an increase in the money supply
is a rise in the interest rate in response to a higher
level of income.
• Price-Level effect of an increase in the money
supply is a rise in interest rates in response to the
rise in the price level.
• The expected-inflation effect of an increase in the
money supply is a rise in interest rates in response
to the rise in the expected inflation rate.
5.29
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Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
5.30
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Money Growth and Interest Rates
5.31
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