Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Bi C
Big
Concepts
t
ECON 354
Money and Banking
Professor Yamin Ahmad
Lecture 4
• The Bond Market
• Demand and Supply for bonds/assets
 What factors determine the demand and supply for
bonds (or loanable funds)?
• Equivalence of Loanable funds and Liquidity
Preference
• Fisher Effect
• Theory of Liquidity
Preference
• Effect of changes in money growth rate on
interest rates
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
D
Demand
d ffor A
Assets
t
Professor Yamin Ahmad, Money and Banking – ECON 354
D t
Determinants
i
t off Asset
A
t Demand
D
d
Relationship to Asset Demand
• Consider an individual’s demand for purchasing
any type of asset.
• Wealth
Positive
• Question: What are some of the factors that
might influence that demand?
• Expected Return
(Relative to other assets)
Positive
• Risk
Negative
• Liquidity
Positive
 Write down a list of the factors that you think might
influence your demand for a particular asset.
• Once we have a list of factors, we can then
derive the demand for that asset
asset.
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Hypothetical
yp
Derivation of Bond
Demand Curve
• Consider a pure 1 year discount bond with a face value
of $1000. The yield on the bond equals:
FP
i  Rte1 
P
• Suppose that the price of the bond is $950. Then the
associated y
yield is:
i
$1000  $950
 0.053  5.3%
$950
Hypothetical
yp
Derivation of Bond
Demand Curve
Point B:
P = $900
i=
($1000 – $900)
= 0.111
0 111 = 11.1%
11 1%
$900
d
• Assume demand at this price is: B = $200 billion
d
Point C: P = $850, i = 17.6% B = $300 billion
d
d
• Assume demand at this price is : B = $100 billion.
billion This
gives us a triplet: (Bd, i, P) = (100 billion, 5.3%, $950).
Refer to this combination (or triplet) as point A.
Point D: P = $800, i = 25.0% B = $400 billion
d
Point E: P = $750, i = 33.0% B = $500 billion
d
Demand Curve is B in Figure 1 which connects points A, B, C, D, E.
Has usual downward slope
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
The Demand For Bonds
Price of Bonds, P($)
Interest Rate i (%)
P Increasing 
i increases 
D i ti off B
Derivation
Bond
dS
Supply
l C
Curve
s
Point F: P = $750, i = 33.0%, B = $100 billion
A
900
5.3
s
Point G: P = $800, i = 25.0%, B = $200 billion
s
B
850
11.1
Point C: P = $850, i = 17.6%, B = $300 billion
s
Point H: P = $900, i = 11.1%, B = $400 billion
C
800
17.6
Point I:
s
P = $950, i = 5.3%, B = $500 billion
s
D
750
25.0
• Supply Curve is B that connects points F, G, C, H, I, and has upward
slope
E
700
33.0
• At lower interest rates, it is less costly to finance borrowing
 Hence more firms are willing to borrow by issuing bonds!
100
200
300
400
500
Quantity of Bonds, B
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Price of Bonds
Bonds, P($)
Professor Yamin Ahmad, Money and Banking – ECON 354
The Supply Of Bonds
The Bond Market
Interest Rate i ((%))
i increases 
P Increasing 
Interest Rate i (%)
Price of Bonds, P($)
i increases 
P Increasing 
900
A
5.3
I
Market Equilibrium
900
I
5.3
d
850
1. Occurs when B =
s
B , at P* = $800, i*
= 17.6%
11.1
H
800
2. When P = $950, i =
s
d
5.3%, B > B
(excess supply): P 
t P*,
to
P* i to
t i*
17.6
C
750
25.0
G
700
33 0
33.0
F
100
3. When P = $750, i =
d
s
33.0, B > B (excess
demand): P  to P*,
i  to ii*
200
300
400
B
850
11 1
11.1
H
C
800
17.6
D
750
25.0
G
E
700
33.0
F
500
100
200
300
400
500
Quantity of Bonds, B
Quantity of Bonds, B
($ Billion)
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Loanable Funds Terminology
Interest Rate i (%)
i increases 
F t
Factors
that
th t Shift th
the B
Bond
dD
Demand
dC
Curve
Demand for bonds, Bd
Supply of Loanable
funds Ls
F
33
1.
2.
Demand for
bonds = supply
off loanable
l
bl
funds
Supply of bonds
= demand for
loanable funds
E
G
25
17.6
H
B
Supply of bonds, Bs
Demand for Loanable
funds, Ld
I
5.3
A
100
200
300
400
 Economy grows, wealth ,
 Bd ,
 Bd shifts out to
right
• Expected Return
D
C
11.1
• Wealth
 If ie  in future, Re for long-term bonds  due to
capital gains
gains, Bd shifts out to right (For a long
term bond)
 e , Relative Re , Bd shifts out to right
 Expected return of other assets , Bd , Bd shifts
out to right
500
Quantity of Bonds, B
Loanable funds, L ($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Shifts in the Bond Demand Curve
F t
Factors
that
th t Shift th
the B
Bond
dD
Demand
dC
Curve
Interest Rate i (%)
Price of Bonds, P($)
i increases 
P Increasing 
• Risk
 Risk of bonds ,
 Bd ,
 Bd shifts out to right
 Risk of other assets , Bd , Bd shifts out to right
A’
A
900
5.3
B’
B
850
11 1
11.1
C’
C
800
• Liquidity
 Liquidity of Bonds , Bd , Bd shifts out to right
 Liquidity of other assets , Bd , Bd shifts out to
right
17.6
D’
D
750
Bd2
25.0
E’
E
700
33.0
Bd1
100
200
300
400
500
Quantity of Bonds, B
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
The Supply Of Bonds
Shifts in Demand Curve For Bonds
IIncreases In
I The
Th
Following Variables
•
Wealth
•
Expected int. rate
Change
in
Demand
Shift
of Bond
Demand Curve
Expected Inflation
•
Risk
i increases 
P Increasing 
•
Profitability of
Investment
Opportunities
 Business cycle
expansion,
investment
opportunities ,
Bs , Bs shifts
out to right
•
•
Interest Rate i (%)
Price of Bonds, P($)
Expected
Inflation
 e , Bs , Bs
shifts out to right
•
Government
Activities
 Deficits ,
,
Bs shifts out to
right
BS1
900
I’
850
11 1
11.1
H
H’
800
17.6
C
750
25.0
G
700
C’
C
G’
BS2
F
33.0
F’
Bs
•
Liquidity
100
200
300
Quantity of Bonds, B
Note: These lecture notes are incomplete without having attended lectures
5.3
I
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
400
500
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Shifts in Supply Curve For Bonds
Change
in
Supply
Shift
of Bond
Supply Curve
• Profitability of
Investments
• E
Expected
t d
Inflation
Changes in e: the Fisher Effect
Interest Rate i (%)
Price of Bonds, P($)
i increases 
P Increasing 
If e 
1. Relative RETe
 Bd shifts
,
hift iin
to left
2. Bs , Bs shifts
g
out to right
3. P , i 
BS1
BS2
1
P1
i1
2
P2
Bd1
• Government
Deficit
i2
Bd2
Q
Quantity
tit off Bonds,
B d
B
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Evidence on the Fisher Effect in the US
percent
per year
15
Fisher Effect: when
expected inflation rises,
interest rates will rise
Interest Rate i (%)
Price of Bonds, P($)
i increases 
P Increasing 
nominal
interest rate
10
5
0
Business Cycle Expansion
1. Wealth , Bd
, Bd shifts out
g
to right
2. Investment ,
Bs , Bs shifts
out to right
3 If Bs shifts
3.
more than Bd
then P , i 
BS1
BS2
1
P1
i2
inflation rate
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Note: These lecture notes are incomplete without having attended lectures.
i1
2
P2
Bd1
Q
Quantity
tit off Bonds,
B d
B
Note: These lecture notes are incomplete without having attended lectures
Bd2
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Evidence on Business Cycles
and Interest Rates
Relation
e at o o
of Liquidity
qu d ty Preference
e e e ce
Framework to Loanable Funds
• Keynes’s
y
Major
j Assumption
p
 Two Categories of Assets in Wealth :
 Money
 Bonds
• Observe: Interest rates rise during business
cycle expansions and fall during recessions
Thus:
Ms + Bs = Wealth
Budget Constraint:
Bd + Md = Wealth
Therefore:
Ms + Bs = Bd + Md
Subtracting Md and Bs from both sides:
Ms – Md = Bd – Bs
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Equivalence
qu a e ce o
of Liquidity
qu d ty Preference
e e e ce a
and
d
Market For Loanable Funds
M
Money
Market
M k t Equilibrium
E ilib i
• Definition: Money Market Equilibrium occurs
when Md = Ms
• Then Md – Ms = 0 which implies that Bd – Bs = 0,
so that Bd = Bs and bond market is also in
equilibrium
• Example of Walras’ Law
Note: These lecture notes are incomplete without having attended lectures
•
Equating supply and demand for bonds as in
loanable funds framework is equivalent to equating
supply and demand for money as in liquidity
preference framework
•
Two frameworks are closely linked, but differ in
practice because liquidity preference assumes only
two assets, money and bonds, and ignores effects
on interest rates from changes in expected returns
on real assets
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Money Market Equilibrium
Li idit P
Liquidity
Preference
f
A
Analysis
l i
Derivation of Demand Curve
• Keynes assumed money has i = 0
• As i , relative RETe on money  (equivalently,
opportunity cost of money )  Md 
• Demand
D
d curve ffor money h
has usuall d
downward
d slope
l
• Suppose that the money market equilibrium
occurs when Md = Ms, at i* = 15%
• If Ms ≠ Md, then interest rate adjusts:
 If i = 25%, Ms > Md (excess supply): Price of bonds ,
i  to i** = 15%
%
 If i =5%, Md > Ms (excess demand): Price of bonds ,
i to
i* = 15%
Derivation of Supply curve
• Assume that central bank controls Ms and it is a fixed
amount
• Ms curve is vertical line
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Money Market Equilibrium
•
If
≠
then
i t
interest
t rate
t
adjusts:
Ms
Md,
 If i = 25%, Ms
> Md (excess
supply): Price
of bonds , i
 to i* = 15%
 If i =5%, Md >
Ms (excess
demand):
Price of
bonds , i
to
i* = 15%
Rise in Income or Price Level
MS
Interest Rate i (%)
i increases 
Interest Rate i (%)
i increases 
MS
A
25
•
B
20
•
•
C
15
D
Income , M ,
d
M shifts out to
right
s
M unchanged
ii* rises from i1
to i2
d
i2
i1
Md2
10
E
5
Md
100
200
Note: These lecture notes are incomplete without having attended lectures
300
400
Quantity of Money, M
($ Billion)
Md1
500
Quantity of Money, M
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Rise in Money Supply
Interest Rate i (%)
i increases 
• Ms , Ms
shifts out to
right
• Md
unchanged
h
d
• i* falls from
i1 to i2
MS1
Summary of Shifts
MS2
Change
in Money
Demand or Supply
Change
in Interest
Rate
i1
i2
Md
• Income
Md 

• Price Level
Md 

• Money Supply
Ms 

Quantity of Money, M
($ Billion)
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Money and Interest Rates
Effects of money on interest rates
1 Liquidity Effect
1.
Ms , Ms shifts right, i 
2. Income Effect
Ms , Income , Md , Md shifts right, i 
3. Price Level Effect
Ms , Price level , Md , Md shifts right, i 
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Eff t off Higher
Effect
Hi h Money
M
Growth
G
th Rate
R t
• Effect of higher rate of money growth on
interest rates is ambiguous
Because income, price level and expected
inflation effects work in opposite direction of
liquidity effect
4. Expected Inflation Effect
Ms , e , Bd , Bs , Fisher
s e effect,
e ec , i 
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Evidence on Moneyy Growth
and Interest Rates
Does Higher
M
Money
Growth
G
h
Lower Interest
R
Rates?
?
• Consider the following
gp
periods: 1960’s,, 1970’s,, 1980’s
Note: These lecture notes are incomplete without having attended lectures
Note: These lecture notes are incomplete without having attended lectures