Lecture
The Behavior of Interest Rates
Chapter 5
Motivation
• Monetary Policy works primarily by
manipulating interest rates
• Interest rates are determined in the bond
market by the demand and supply for
bonds
• Interest rates change because of shifts
in demand and supply for bonds
Interest Rates on Selected Bonds, 1950–2015
Three things this graph demonstrates??
3-month Bill
10-year Treasury
10-year Corporate Baa
We look at three perspectives on the bond market
• Bonds as financial assets: Theory of asset demand and
asset allocation. S&D for Bonds.
• Loanable funds: Supply & Demand for loanable funds.
Savings and Investment. Bond demand is one component
of the aggregate supply of loanable funds.

What’s being traded - Bonds or the use of funds?
• Liquidity Preference: View bonds as an alternative to
holding money.
Bonds as a Financial Asset
Demand for Financial Assets
• 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
Demand for Financial Assets
Holding all other factors constant, the demand
for an asset is:
•
positively related to wealth
•
positively related to its expected return
relative to alternative assets
•
negatively related to the risk of its returns
relative to alternative assets
•
positively related to its liquidity relative to
alternative assets
Demand and Supply Curves for Bonds
• At lower prices (higher interest rates),
ceteris paribus, the quantity
demanded of bonds (lenders) is
higher - an inverse relationship
• At lower prices (higher interest rates),
ceteris paribus, the quantity supplied
of bonds (borrowers) is lower - a
positive relationship
This example is for a one-year zero coupon bond
Market Equilibrium
• Occurs when the quantity that people are willing to
buy equals the quantity that people are willing to
sell at a given price.
• Bd = Bs : the equilibrium or market clearing price
and interest rate.
• When Bd > Bs : excess demand, investors will bidup the price and interest rate will fall.
• When Bd < Bs : excess supply, sellers will lower the
price and interest rate will rise
How Factors Shift the Demand Curve
1. Wealth/saving
•
•
•
•
As economy grows, income and wealth
increase
Bd  => Bd shifts out to right
As economy contracts, income and
wealth fall
Bd , => Bd shifts in to left
How Factors Shift the Demand Curve
2. Expected Returns on bonds
•
If i  is expected to fall in future,
expected return for long-term bonds 
•
Bd shifts out to right (increase in demand)
•
If i is expected to rise in future, expected
return for long-term bonds 
•
Bd shifts in to left (decrease in demand)
How Factors Shift the Demand Curve
3. Expected Returns on other assets
─
As the expected return on other asset
increase relative to return for long-term
bonds
─
Bonds become less attractive
─
Bd shifts in to left (decrease in demand)
How Factors Shift the Demand Curve
4. Risk •
Risk of bonds , Bd 
•
Bd shifts out to right
•
Risk of other assets , Bd 
•
Bd shifts out to right
How Factors Shift the Demand Curve
• 5. Liquidity
•
Liquidity of bonds , Bd 
•
Bd shifts out to right
•
Liquidity of other assets , Bd 
•
Bd shifts out to right
Shift in the Demand Curve for Bonds
Shifts in the Supply of Bonds
1. Expected Profitability of Investment
Opportunities:
in a business cycle expansion, the supply of bonds
increases, conversely, in a recession, when there are far
fewer expected profitable investment opportunities, the
supply of bonds falls
2. Expected Inflation:
an increase in expected inflation causes the supply of bonds
to increase
3. Government Activities:
higher government deficits increase the supply of bonds,
conversely, government surpluses decrease the supply of
bonds
Shift in the Supply Curve for Bonds
Case Study - Response to an Expected
Increase in the Rate of Inflation
Expected Inflation and Interest Rates (ThreeMonth Treasury Bills), 1953–2011
FIGURE 7 Business Cycle and Interest Rates (Three-Month Treasury
Bills), 1951–2008
Response to a Business Cycle Expansion
What Happened in May 2013?
5-22
What
happened
here?
Loanable Funds - Use of Funds Approach
1. Demand for
bonds = supply
of loanable
funds
2. Supply of bonds
= demand for
loanable funds
Liquidity Preference Framework
• proposed by John Maynard
Keynes.
• from the perspective of
‘money’
• assume there are 2 assets:

bond + money = total wealth
25
The Liquidity Preference Framework
two assets: bonds + money = total wealth
 supply side:
Ms + Bs = Wealth
 demand side:
Bd + Md = Wealth

Ms + Bs = Bd + Md
Re-arranging:

Ms – Md = Bd – Bs
d - Ms
M
Conclusion:
If money market is in equilibrium (money
demand equals money supply: Md = Ms ), then
bond market is also in equilibrium (bond
demand equals bond supply: Bd = Bs).

Keynesian Liquidity Preference Analysis
Derivation of Demand Curve
• As i , the opportunity cost of holding money 
 Md . The demand curve for money has the
usual downward slope
Derivation of Supply curve
• Assume that central bank controls Ms and it is a
fixed amount. Ms curve is vertical line
Market Equilibrium
• Occurs when Md = Ms
Equilibrium in the Market for Money
Market equilibrium
•
•
equilibrium quantity of money: Md = Ms
equilibrium interest rate: i*
•
If i > i* , Ms > Md (excess supply of
money)

•
Central bank supply of money is greater
than the amount of money people are willing
to hold  price of bonds , i  back to i*
If i < i*, Md > Ms (excess demand for
money)  price of bonds , i  back to i*
29
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
Increase in Income or the Price Level
Shifts in the Supply of Money
• The supply of money is controlled by the
central bank
• An increase in the money supply by the
Federal Reserve will shift the supply
curve for money to the right
Response to an Increase in Money Supply
Does Everything Else Remain Equal?
• Liquidity preference framework says that an
increase in the money supply will lower
interest rates, if other things remain
unchanged - the liquidity effect.
•
Noble prize winner Milton Friedman argued:
• Over time, as the economy expands and
income increases, get an Income Effect.
The demand curve for money, Md , shifts to
the right and interest rates begin to rise.
Everything Else Remaining Equal (?)
• Also, over time, can get a Price Level effect.
A rise in the price level causes demand
curve for money to shift to the right which will
cause interest rates to rise.
• There may also be an Expected-Inflation
effect which causes an increase in interest
rates because the increase in the money
supply may lead people to expect a higher
price level in the future (the demand curve
shifts to the right).
Read Mishkin Carefully - Note the shift from “money supply” to
“growth in the money supply”.
Price-Level Effect and Expected-Inflation Effect
• A one time increase in the money supply will
cause prices to rise to a permanently higher level
by the end of the year. The interest rate will rise
via the increased prices.
• A rising price level will raise interest rates because
people will expect inflation to be higher over the
course of the year. When the price level stops
rising, expectations of inflation will return to zero.
Read Mishkin Carefully - Note the shift from “money
supply” to “growth in the money supply”
Price-Level Effect and Expected-Inflation Effect
• Expected-inflation effect persists only as
long as the price level continues to rise
which requires continued money growth.
Money Supply Growth and the Effects on
Interest Rates
Liquidity Effect:
Ms growth  i 
Income Effect:
i  Income   Md   i 
Price Level Effect: Income   Price level  Md  i 
Expected Inflation Effect: Ms   Price level  πe   Bd  
Bs   Fisher effect  i 
What’s the net effect on interest rate?
Effect of higher rate of money growth on
interest rates is ambiguous.
When
Does
Higher
Money
Growth
Lower
Interest
Rates?