Interest Rate Determination
This chapter: What makes interest
rates move up or down?
Do not confuse with: What makes
interest rates different, such as
secondary market, default risk, etc.
Apply Demand and Supply
analysis to bond market.
Summary Results:
Shifts in Bond Demand
Increase in Bond Demand: DB
(Rightward shift in Demand for Bonds)
DB  i*
Decrease in Bond Demand: DB
(Leftward shift in Demand for Bonds)
DB  i*
Shift Variables:
Bond Demand
Wealth -- increases in Wealth
increase the Demand for Bonds
Expected Inflation (e),
e  DB  i*
Return or Expected Return on
Alternative Assets
Interest Rates on Bonds of
Similar Maturity (for specific
bond)
Expected Rate of Return on
Stock (RETe)
Expected future interest rates
(ie), ie  DB  i*
Interest rates on foreign bonds
Market Risk of Bonds and
Alternative Assets
Market Risk of Bonds (B)
B  DB  i*
Market Risk of Stock (S)
S   DB  i*
Changes Affecting Structural
Differences
Changes in Risk Rating of an
individual firm (Default Risk)
Changes in Marginal Tax Rate -affects the Demand for Municipal
Bonds
Summary Results:
Shifts in Bond Supply
Increase in Bond Supply: SB
(Rightward shift in Supply of bonds)
 SB  i*
Decrease in Bond Supply: SB
(Leftward shift in Supply of bonds)
SB  i* 
Shift Variables:
Supply of Bonds
Expected Inflation (e),
e  SB  i*
Size of Deficits and National Debt
Debt   ST-BILLS  i*
Size of State and Local
Government Debt
Debt   SMUN  i*
More Shift Variables:
Bond Supply
Desire for Firms to Undertake
Investment Projects
Investment   SCORP  i*
Loan Demand Faced by Banks
Loan Demand   SCD  i*
General Conclusions –
Interest Rates
Many factors (not just the Federal
Reserve) change interest rates.
Interest rate movements tend to
be procyclical, or vary positively
with the growth the economy.
The Federal Reserve and
Interest Rates
Federal Reserve -- practices monetary
policy through Open Market
Operations, the buying or selling of
bonds (generally T-Bills).
Expansionary Policy (addressing
sluggish economy or recession):
Fed buys bonds
Contractionary Policy (addressing
inflation): Fed sells bonds
Dual Effects:
Monetary Policy
Example – Federal Reserve practices
Expansionary Policy to try to improve
sluggish economy
Liquidity Effect:
Fed buys more bonds  DB  i*
Expected Inflation Effect:
Expansionary policy  e  i*
Overall Effect --- Which one dominates?