#### Transcript on Interest Rates

```The Behavior of Interest Rates
Chapter 5
1
2
Nominal Interest Rates
Nominal interest rates on 3-mo. Treasury
Bills were about 1% in the fifties. In the
eighties they were 15%. At the end of
2000, they were above 6%; in the middle
of 2003, they were 1%.
 What is the explanation for these interest
rate fluctuations?
 The explanation for “the” nominal interest
rate should apply to all nominal rates since
interest rates usually move together.

3
Determinants of Asset Demand
The higher the wealth of an individual, the
higher will be her demand for assets, both
financial and real.
 The higher the expected return from an
asset compared to other assets, the higher
the demand for that asset.
 The riskier an asset is, the less there will
be a demand for it.
 The more liquid an asset is, the higher the
demand will be.

4
Bond Price and Interest Rate





Bond prices and interest rates are always
inversely related.
A discount bond that matures a year from now and
priced at \$900 carries an interest rate of (1000900)/900=11.1%.
A discount bond that matures a year from now and
priced at \$800 carries an interest rate of (1000800)/800=25%.
A console that pays \$100 per year and sells for
\$1000 carries an interest rate of 10%.
The same console when sold at \$1250 carries an
interest rate of 8%.
5
Demand for Bonds




In boom times wealth (and income) rise.
Demand for bonds will rise, too. During
recessions demand for bonds will fall.
If interest rates in the future are expected to
fall, long-term bonds will have capital gains
and increased returns, raising the demand for
bonds.
If the prices of bonds become more volatile,
the demand for bonds will fall.
If bonds became more liquid relative to other
assets, the demand for bonds will increase.
6
Measuring Demand for Bonds
Typical demand curve would have price
of bonds on the vertical axis and
quantity of bonds on the horizontal axis.
 If bonds were the only form for funds to
be raised, then those who demand to
purchase bonds are the ones who
supply funds.
 Demand for bonds is mirror image of
supply of loanable funds.

7
Bond Price and Interest Rate
P
i
\$900
11.1%
\$800
25%
i
P
25%
\$800
11.1%
\$900
Quantity
Loanable
of bonds
funds
An increase in the demand for bonds is the same as an increase
in the supply of loanable funds.
8
Demand and Supply
As the price of bonds falls, lendersavers will want to buy more: demand is
downward sloping.
 As the interest rate rises, lender-savers
will want to supply more funds into the
market: supply of loanable funds is
upward sloping.

9
Demand and Supply
As the price of bonds falls, borrowerinvestors will be more reluctant to issue
bonds: the supply of bonds will be
upward sloping.
 As the interest rate rises, borrowerinvestors will be more reluctant to
borrow: demand for loanable funds will
be downward sloping.

10
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
11
Supply of Bonds

Increased confidence of producers means higher
expected profits: they tend to borrow more.


A rise in the expected inflation, given nominal
interest rates, would lower the cost of borrowing
(real interest rate).


Increase supply of bonds = Increase demand for
loanable funds
Increase supply of bonds = Increase demand for
loanable funds
Higher government deficits are financed by
government borrowing.

Increase supply of bonds = Increase demand for
loanable funds
12
Impact on Interest Rates of a Sudden
Increase in the Volatility of Gold Prices
i
P
Gold becomes a
riskier asset. Bonds
become relatively
attractive. Demand for
bonds increases. Price
of bonds rise and interest
rate falls.
P
P
Q of bonds
13
Impact on Interest Rates When Real
Estate Prices Are Expected to Rise
P
P
i
i
The expected returns from real
estate increases. Bonds become
less attractive; demand drops.
Price of bonds fall and interest
rates rise.
Quantity of bonds
14
Impact on Interest Rates When
Recession Occurs
P
P
During recessions, investment
scrap expansion plans. New
i bonds are not issued. Supply of
i bonds falls. The wealth effect
of the recession will reduce the
demand for bonds, too. The net
result is increase in the price of
bonds and decrease in the interest
rates.
15
http://research.stlouisfed.org/fred2/graph/?id=DTB3,
16
Impact on Interest Rates When
Expected Inflation Falls
P
P
P
Q of bonds
When expected inflation falls,
the expected return on bonds
i rises: bondholders expect
capital gains. Demand shifts
i to the right. On the other hand,
at a given nominal interest rate,
the fall in expected inflation
raises the real interest rate. The
cost of borrowing increases,
lowering the supply of bonds.
Price rises, interest rate falls.
17
Expected Inflation and Interest Rates (ThreeMonth Treasury Bills), 1953–2008
Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real
Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy
15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past
interest rates, inflation, and time trends.
18
Japan

Japan experienced a prolonged recession for two

Demand and supply of bonds both fell, raising the
price of bonds and lowering the interest rate.

Prolonged recession created deflation, making the
expected return on real assets negative.

Money (cash) became more desirable. Bonds
less desirable than money but still preferable to
real assets.

Interest rates in Japan were close to zero.
19
Response to a Business Cycle Expansion
If this depiction is true,
what should we see
happen to interest
rates?
20
http://www.economist.com/finance/displaystory.cfm?story_id=8641615
21
Impact on Interest Rates When U.S. Started
To Retire Long-Term Debt in 1999
P
i
P
i
The announcement that the
bonds raised the price of these
bonds and reduced the interest
rate on these bonds. As a result,
the yield curve turned down at
the long-term maturity end.
22
Impact of Low Savings on
Interest Rates
US personal savings rate (Personal income
- Consumption) was at all time low in 19992000.
 Low savings imply shrinking of lender-saver
funds.
 As loanable funds shrink the demand for
bonds falls.
 The price of bonds falls and interest rate
rises.

23
Liquidity Preference Framework

We have seen that interest rates can be
determined using the equilibrium in the bond
market or its mirror image, loanable funds
market.


Those who buy bonds are the ones who loan
funds and those who sell bonds are the ones
who borrow.
If bonds and money are the two categories
of assets people use to store wealth, then
equilibrium in bond market will imply
equilibrium in the market for money.
24
How To Divide Assets Into
Money and Bonds

Money
Currency
 Demand deposits


Bonds
Savings deposits
 Time deposits
 Bonds
 Stocks

25
Equilibrium in Bond Market =
Equilibrium in Money Market

Total supply of wealth has to equal to total
demand for wealth:
 Ms
+ Bs = Md + Bd
If the bond market is in equilibrium, Bs =
Bd.
 Therefore, the market for money must be
in equilibrium, Ms = Md.

26
Bond vs. Money Market
Equilibrium in the bond market determines
bond prices and interest rates, since each
bond price is associated with a unique
interest rate.
 Equilibrium in the market for money also
determines the interest rate.
 The approaches are interchangeable,
though the effects of some variable
changes are easier to observe in one
approach over the other.

27
Liquidity Preference

Why do people want to hold money?
To conduct purchases; for transaction
purposes.
 Keynesian definition of money concentrates on
the medium of exchange function and
assumes that the return on money is zero.


What makes people to hold more money?
Income increases.
 Price level increases.
 Interest rate drops.

 Opportunity
cost of holding money drops.
28
Liquidity Preference = Md
The demand for money is drawn with
interest rate on the vertical axis and quantity
of money on the horizontal axis.
 The higher the interest rate, the higher is the
opportunity cost of holding money, and the
lower is the amount of money held.
 The demand for money becomes a
downward sloping curve, a typical demand
curve.
 Increases in income and/or the price level
shift the curve to the right.

29
Equilibrium in the Market for Money




For the time being, we will assume that the supply
of money is determined by the monetary authority,
the central bank.
Equilibrium between supply and demand for
money takes place at a unique interest rate.
If at a given interest rate, Md > Ms, then people will
sell bonds to convert them to cash. Bond prices
will go down. Interest rates will go up, reducing
Md.
If Md<Ms, people will convert money into bonds.
The price of bonds will go up, lowering the interest
rate until Md=Ms.
30
Impact of an Increase In Income
i
i
M
P
i
P
i
Q of bonds
31
Impact on Interest Rates of an Increase
in the Price Level
P
i
i
M
Q of bonds
Price level increase forces people to hold more money
to make the same purchases. The adjustment in the
liquidity preference framework comes about as people
sell their bonds and keep cash. In the bond market, the
supply of bonds rises, lowering the price and raising
the interest rate.
32
Impact on Interest Rates of an
Increase in Ms
i
P
M
i
Q of bonds
In the liquidity preference framework, increase in the money
supply is shown by a rightward shift of Ms. An excess of Ms
over Md prompts people to buy bonds and thus raise the price
of bonds, lowering the interest rate.
33
Impact on Interest Rates of A Rise in
Expected Inflation
i
P
Q of bonds
M
An increase in the expected inflation will lower the expected returns
on bonds because interest rates will rise forcing capital losses on bonds.
On the other hand, bond issuers will expect to pay lower real interest
rates in the future and increase their supply. Prices of bonds will fall
and interest rates will rise. In the liquidity preference framework, the
reluctance of bondholders to hold bonds translates into an increase in
the demand for money and a rise in the interest rate.
34
A Rise in the Money Supply May Not
Lower Interest Rates in The Long-Run
Ms up => i down (liquidity effect)
 i down => I up => Y up (income effect) =>
Md up
 Y up => P up (price level effect) => Md up
 P up => expected inflation up (expected
inflation effect) => Md up
 In the liquidity preference framework,
income and price level effects will directly
translate into a rightward shift of Md.

35
Possible Outcomes



If the liquidity effect is larger than the other
effects, an increase in Ms will lower interest rates.
If the liquidity effect is smaller than other effects
but expectations adjust slowly, an increase in Ms
will lower the interest rates initially but will raise
them in the long run.
If the liquidity effect is smaller than other effects
and expectations adjust quickly, an increase in
Ms will only bring an increase in interest rates.
36
37
Quarterly Money Growth Rates
and Short Term Interest Rate
38
Annual Money Growth Rates
and Short Term Interest Rate
39
Annual Money Growth Rates
and Short Term Interest Rate
40
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