Chapter 5 - The Behavior of Interest Rates
Nominal interest rates on U.S. Treasury bills
in the early 1950s were approximately 1%
(annual rate). By 1981 they were over 15%,
fell to 3% in 1993, and then stabilized around
5% during the mid- to late-1990s.
 What explains these sizable fluctuations?
 How is the overall level of nominal interest
rates determined, and what factors influence
their behavior?
 From Chapter 4, if we can explain why
bond prices change, can we explain why
interest rates fluctuate?
 Modeling of Bond Market and Money
Market using supply and demand concepts
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Theory of Asset Demand
What determines the quantity demanded of
an asset?
asset - piece of property that stores value
(money, bonds, stocks, art, house, etc.)
ceteris paribus (c.p.) - Latin for "other things
being equal"…or, "holding all else constant"
Theory of Asset Demand - Four Factors:
1. Wealth
 wealth
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
more resources available
to purchase assets with

 Qd for assets (at every
price level…c.p.)
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2. Expected Returns
 From Chapter 4, return on an asset (bond)
measures how much we gain from holding
the asset
 If the expected return on a bond rises,
relative to the expected returns on alternative
assets (c.p.), bond a more desirable purchase
 expected
return of
asset
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
increase in
quantity demanded
for that same asset
(ceteris paribus)
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Risk
The degree of risk or uncertainty of an asset's
return also affects the demand for the asset…
Consider two assets, stock in Safe-Invest,
Inc. that has a fixed return of 10%, and stock
in Reynolds, Inc. that has a return of 15%
half of the time, and 5% other half of time.
Reynolds, Inc. stock has uncertainty
associated to its returns… greater risk.
Risk-averse individuals (most of us) will
prefer Safe-Invest, Inc. stock, even though
the expected return for both stocks are the
same (10%). Risk-preferrer (risk-lovers)
will opt for the Reynolds stock.
 an asset's risk   Qd of that asset (c.p.)
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Liquidity
How quickly asset can be converted to cash
without incurring large costs is important.
If the asset's market has many buyers/sellers,
the asset is liquid (it has depth and breadth).
Houses not liquid… not many buyers/sellers,
and there are large transaction costs.
U.S. T-bills are highly liquid assets… market
has many buyers/sellers and costs to buy/sell
are low.
 liquidity
of an
asset

 Qd
of that
same asset
 Table 1 - Determinants of Asset Demand
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Demand in the Bond Market
bond demand curve - relationship between
Qd for bonds & bond price, ceteris paribus
Discount bond, $1000 face value (F), one
year holding period… the return on bond was
equal to interest rate, as measured by YTM
In other words, expected return on this bond
was equal to the interest rate…
FP
i  RET 
P
e

between i and P
มีความสัมพันธ์ทแี่ ปรผกผันกันระหว่างอัตราดอกเบี้ยและราคาของหลักทรัพย์
(
Inverse
relationship
)

Qd
เส้นอุปสงค์ของหลักทรัพย์ (
(
Bd curve
) จะมีความชันเป็ นลบ แสดงว่าเมื่อราคาของหลักทรัพย์เพิม่ ขึ้น ปริ มาณความต้องการหลักทรัพย์จะลด
) ลดลง
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รู ปที่ 1 อุปทานและอุปสงค์ของพันธบัตร (
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Supply and Demand for Bonds)
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อุปทานในตลาดพันธบัตร
เส้นอุปทานของพันธบัตร (
(Supply in the Bond Market)
bond supply curve –
ceteris paribas)
)
ความสัมพันธ์ระหว่างอุปทานของพันธบัตรและราคาของพันธบัตรโดยกาหนดให้ตวั กาหนดอื่นๆ อยูค่ งที่ (
ในตัวอย่างพันธบัตรของเรานี้ ถ้าราคาพันธบัตร (
อัตราดอกเบี้ยลดลง
Pbond
) เพิ่มขึ้น อัตราดอกเบี้ยลดลง สิ่ งที่ใช้ในการอธิบายอุปทานคืออะไร

?
ต้นทุนลดลงในการออกพันธบัตร
บริ ษทั เต็มใจที่จะกูย้ มื

เพื่อกูเ้ งินโดนผ่าน
การออกพันธบัตร

ปริ มาณของพันธบัตรในตลาดเพิม่
สู งขึ้น

 Bs curve has upward slope indicating that
as the price for bonds increases, Qs increases
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Bond Market Equilibrium
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
Bd = Bs
 Price where the Qdbonds = Qsbonds is known
as the market-clearing price (equilib. price)
 Interest rate that corresponds to this price is
called the market-clearing interest rate
(equilibrium interest rate)
 Excess supply and excess demand…
the price level always converges toward
market-clearing price (and therefore, a
market-clearing interest rate)
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Bond Market vs. Loanable Funds Market
 Supply and demand diagram can be drawn
for any type of bond, since interest rate and
bond price are always negatively related
 We're more concerned with value of
interest rates than of bond prices, so
reformulate the supply-demand diagram
 Problem: making interest rates run in the
"usual" direction on the vertical axis
 Quantity of bonds still on the horizontal
axis… but now, just call the bonds loanable
funds, a quantity of loans
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Bond Market vs. Loanable Funds Market
 Supply of bonds (Bs) equivalent to the
demand for loanable funds (Ld)
 Firm supplying bonds is really just taking
out a loan from the person buying the bond
(supplying a bond same as demanding a loan)
 Demand for bonds (Bd) equivalent to the
supply of loanable funds (Ls)
 Buying a bond same as supplying a loan
 Inverse relationship between bond prices
and interest rates still intact
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รู ปที่ 2
- Loanable Funds and Bonds
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Changes in Equilibrium Interest Rates
 Movements along curves versus shifts in
the curves
 With bond price (or interest rate) change,
movement along the curve (change in either
Qd or Qs)
 If determinant other than bond price (or
interest rate) changes, shift in the curve (shift
in entire demand curve or supply curve)
 Shifts in curves indicate new equilibrium
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Shifts in Bond Demand Curve
 Factors from asset demand theory (and
some other factors) shift the demand curve
for bonds (ceteris paribus)
 Table 2 - Factors that Shift Bond Demand
business cycle
expansion
 expected
interest rates
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
wealth increases

Bd shifts right

 expected return
for long-term bonds

Bd shifts left
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Shifts in Bond Demand Curve
 Changes in expected returns on assets also
can shift Bd
If individuals suddenly optimistic about
stocks, and begin to expect higher stock
returns… expected returns on bonds fall
relative to stocks (Bd shifts left)
 If expected inflation increases, higher
prices physical assets like cars and homes…
higher nominal capital gains on real assets
Again, expected returns on bonds fall,
relative to other real assets (Bd shifts left)
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Shifts in Bond Demand Curve
bond prices become
more volatile

 riskiness
of bonds

Bd shifts left
 Another asset market could experience
volatility also, and bonds would become
more attractive (Bd shifts right)
buying/selling
bonds becomes
easier & quicker

 liquidity of bonds

Bd shifts right
 Another asset market could experience
increased liquidity also, and bonds would
become less attractive (Bd shifts left)
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Shifts in Bond Supply Curve
 Three main factors shift the supply curve
for bonds (ceteris paribus)… expected profit,
expected inflation and government activities
 Table 3 - Factors that Shift Bond Supply
 expected
firm profit
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
firm more willing
to borrow and
finance investment

demand for loanable
funds increases

supply of bonds
increases

Bs shifts right
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Shifts in Bond Supply Curve
 Real cost of borrowing accurately measured
by the real interest rate (nominal interest less
expected inflation)
 expected inflation

 real cost of
borrowing

Bs shifts right
 U.S. Treasury issues bonds to finance
government deficits. When deficits are large,
Treasury sells more bonds
higher gov't deficits
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 more bonds issued

 supply bonds

Bs shifts right
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The Fischer Effect
We know that expected inflation affects
nominal interest, via the Fisher equation.
Is the equilibrium interest rate affected also?
 Expected inflation shifts bond demand
 expected inflation
 expected return
 on bonds (relative
to real assets)

Bd shifts left
 Expected inflation also shifts bond supply
 expected inflation
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
decrease in the
real cost borrowing

Bs shifts right
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The Fischer Effect
 Figure 5 - Change in Expected Inflation
 When expected inflation rate increases, the
interest rate increases (Fisher effect)
 While interest rate increases, equilibrium
quantity of bonds could either rise or fall
…depends on magnitudes of shifts
 Figure 6 - Expected Inflation and
Interest Rates, 1953-1999
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Business Cycle Expansion
business cycle
expansion

 production of
goods & services

 national income
firms more willing
 to borrow since more
profit opportunities

business cycle
expansion
more bonds supplied
(Bs shifts right)
 wealth
 (asset demand theory)
 bond demand rises
(Bd shifts right)
 Figure 7 - Business Cycle Expansion
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Liquidity Preference Framework
 Loanable funds framework determines the
equilibrium interest rate using the supply and
demand for bonds (bond market)
 Alternative model known as the liquidity
preference framework determines the
equilibrium interest rate using the supply and
demand for money (money market)
 Developed by John Maynard Keynes
 Two market models related in the
assumption that individuals hold two main
assets to store wealth: bonds or money
total wealth
in the
economy
(Bd + Md)
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=
total
total
quantity + quantity
of bonds
of money
(Bs)
(Ms)
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 Total wealth for economy must equal total
bonds supplied plus total money supplied
 Total wealth must also equal total bonds
demanded plus total money demanded,
…since people cannot purchase more assets
than their available resources allow
Conclusion:
B s + Ms = B d + Md
Rewrite equation as…
B s - B d = M d - Ms
 If the money market is in equilibrium
(Md = Ms), then the bond market is also in
equilibrium (Bd = Bs)
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 Liquidity preference framework (money
market) practically equivalent to the loanable
funds framework (bond market) …then, why
use both?
 Changes in expected inflation easier to
analyze in the bond market
 Changes in income, price level or supply of
money easier to analyze in the money market
 Just as before when the interest rate was a
measure of the opportunity cost of borrowing
money…
…now, the interest rate measures the
opportunity cost of holding money (the
amount sacrificed by not holding alternative
assets…bonds)
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Money Demand and Money Supply
 Quantity of money demanded (Qd) and the
interest rate are negatively related
 interest rate 
opportunity cost of
holding money rises

money becomes less
desirable

Qd of money falls
(mov't. along curve)
 Money Demand curve slopes downward
 Money supplied in the economy controlled
by the central bank (Fed Reserve) and is
fixed at a specific quantity…

Money Supply curve vertical
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Money Market - Supply and Demand
 Movements along curves versus shifts in
the curves
 With interest rate change, movement along
the curve (change in Qd of money)
 If determinant other than interest rate
changes, shift in the curve (shift in entire
demand curve or supply curve)
 Shifts in curves indicate new equilibrium
 Equilibrium occurs where quantity of
money demanded equals quantity of money
supplied, or where the two curves intersect…
Md = Ms
 Figure 10 - Equilibrium in Money Market
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Money Market - Supply and Demand
 Excess supply and excess demand…
just as before, the interest rate always
converges toward the market-clearing level
excess supply
of money

people are holding
more money than
they desire

get rid of money
by buying bonds

bond prices bid up

 interest rate
 Similar situation with excess demand for
money, but reverse scenario… money is
demanded, sell bonds,  Pbonds,  interest rate
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Shifts in Money Demand Curve
Two effects…income effect and price effect
1. Income Effect
Two reasons why income would affect the
demand for money (Figure 11)…
economy expands 


incomes rise
wealth rises
people will want to
hold more money as
store of value
economy expands 
incomes rise
 people will increase
amount of transactions
using money
 income
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
Md curve shifts right
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2. Price Effect
People care about the amount of money they
hold in real terms… what amount of
goods/services they can buy with the money
they hold
 price level

same nominal quantity
of money no longer
as valuable

more (nominal) money
demanded to restore
money in real terms
to former levels

Md curve shifts right
 Figure 11 - Price Level Response
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Shift in Money Supply Curve
For now, only Fed Reserve assumed to
change money supply…
 money supply  shift MS curve right
 Figure 12 - Money Supply Response
What Happens To Interest Rates?
 Table 4 - Factors That Shift MD and MS
 Recall, money supply curve is vertical
 If the money demand curve shifts right
(left), interest rate rises (falls)
 If the money supply curve shifts right,
interest rate falls
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Is There More than Keynes' View?
 Liquidity preference analysis of an increase
in MS leading to lower interest rates appears
valid… but does it stop there? Should money
and interest rates be negatively correlated?
 Milton Friedman agreed…  MS leads to
lower interest rates everything else equal
(liquidity effect)… but does an  MS leave
everything else equal? Not necessarily…
 MS
 expansionary effect on economy
  incomes and  wealth
 interest rates should rise
(income effect)
 MS
 rise in the price level
 interest rates should rise
(price level effect)
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Money Supply Growth and Interest Rates
 Expected-inflation effect
 MS over time 
people will come to
expect higher price level
in the future

 expected inflation

 interest rates
(via bond market)
 Price level effect and expected-inflation
effect differ…
Price level effect remains even after prices
have stopped rising, whereas the expectedinflation effect disappears
 Figure 14 - Money Growth & Interest Rates
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