Chapter 6
Determining Market Interest Rates
Bond Market
• Economists use supply and demand to analyze
markets for non-differentiated goods like flour or
corn.
• In real world financial markets, there is a wide
variety of bonds with different qualities and
different prices/yields at any given time.
• In theory, we will abstract from these differences
to analyze the price/yield of a generic,
representative bond.
• Next chapter, we ask “Why do interest rates vary
among bonds?”
Savers & Borrowers
•
The bond market is made up of two types of
traders. Savers have excess funds today and are
trying to exchange them for bonds (savers).
Borrowers are trying to exchange bonds for
funds today (borrowers).
•
We can think of this market from two
inverse perspectives.
1. Bond Market Perspective
2. Loan Market Perspective
Bond Market Perspective
• Borrowers are sellers of bonds represented
by a supply curve relating the quantity of
bonds they sell at a given bond price, P.
• Savers are buyers of bonds represented by
a demand curve relating the quantity of
bonds they buy at a given bond price, P.
• Quantity: Dollar value of bonds
• Price: Dollar price of bonds.
Loanable Funds Market
Perspective
• Savers are providers of funds to the bond
market represented by a supply curve
relating the quantity of funds they provide
at a given bond interest yield, i.
• Borrowers are takers of funds represented
by a demand curve relating the quantity of
funds they take at a given interest yield, i.
• Quantity: Dollar value of funds
• Price: Bond yields
Views of Excess Funds Holders :
Loanable Funds Perspective
Views of Excess Funds Holders:
Bond Market Perspective
• Q: Why does the Supply Curve for
Loanable Funds Slope Up?
A: Holding expected inflation constant,
a high interest rate on bonds increases the
attractiveness of bonds and attracts more
funds.
• Q: Why does the Demand Curve for Bonds
Slope Down. A high price for a given future
face value reduces the attractiveness of
bonds and attracts fewer funds.
• Q: Why does the Demand Curve for Loanable
Funds Slope Down?
A: If bond issuers must offer a high interest
payment to borrow, the attractiveness of
borrowing or financing borrowing in the bond
market will drop.
• Q: Why does the Supply Curve for Bonds Slope
Up.
A: If bond issuers receive a high price for a
given future face value, the attractiveness of
borrowing or financing in the bond market rises.
Views of Bond Issuers
Excess Supply, Excess Demand,
and Equilibrium
•
•
1.
2.
3.
4.
5.
Q: What causes the the Supply Curve for Loanable
Funds (Demand Curve for Bonds ) to shift?
A: The elements of portfolio allocation.
An increase in wealth shifts supply of loanable funds and demand
for bonds to the right as investors increase the size of their
portfolio.
An increase in expected inflation reduces the real returns from
bonds. This shifts the supply of loanable funds in bond markets and
demand for bonds to the left .
An increase in the expected returns on other assets besides bonds
will shift the supply of loanable funds and demand for bonds to the
left as portfolio holders shift to other assets.
An increase in the risk of bonds (relative to other assets) or an
increase in the cost of acquiring information (relative to other assets)
will shifts the supply of loanable funds and demand for bonds to the
left as portfolio holders shift to other assets.
An increase in the liquidity of bonds (relative to other assets) will
shift the supply of loanable funds and demand for bonds to the
right as portfolio holders shift to other assets.
Shift Chart
Event
Shifts LS
Shifts BD
Wealth


E 


Alternative Asset
Returns 


Relative Bond
Risk 


Relative Bond
Liquidity 
Relative Bond
Information Costs





6
11000
5
10500
10000
4
9500
3
9000
2
1999
2000
DOW
2001
TBILL
2002
Impact of Shift in Supply of Loanable
Funds (Demand for Bonds)?
Event
Wealth
E 
Quantity of Bond Prices
Loanable
Funds/Bonds

wait

wait
Bond Yields

wait
Alternative
Asset Returns 



Relative Bond
Risk 



Relative Bond
Liquidity 



Relative Bond
Information
Costs 



•
•
•
Q: What causes the supply of bonds or the demand for
loanable funds to shift?
New issuers of bonds will be firms financing capital
investment or governments financing deficits.
Firms will issue new bonds if expected real interest rates
fall or after tax profits from capital rise.
1.
2.
3.
•
If expected inflation rises, expected real interest rates fall and
bond supply/loanable funds demand shifts right .
If productivity of capital equipment rises, profits from capital
investment rises and bond supply/loanable funds demand shifts
right .
If business taxation rises, profits from capital investment falls
and bond supply/loanable funds demand shifts left.
Government will issue new bonds if government deficits
increase.
1.
If deficits increase, bond supply/loanable funds shifts right .
Event
Demand for
Loanable Funds
E 

Capital Productivity 

Business Taxes 

Deficits 

Supply of Bonds




Impact of Shift in Demand of Loanable
Funds (Supply of Bonds)?
Event
E 
Quantity of Bond Prices
Loanable
Funds/Bonds
ambiguous

Bond Yields

Capital
Productivity 



Business Taxes




Deficits 



Hong Kong Dollar Bond Market
• Hong Kong Dollar Linked to US dollar.
• Supposing the representative Hong Kong Dollar
bond was about as risky as the representative US
dollar bond, the interest rate should be the same.
• If there are any differentials, the supply curve for
HK loanable funds (the demand curve for HK
bonds) shifts until the two interest rates are equal.
• The HK dollar bond market adjusts to the US
dollar market because the US dollar market is so
much larger.
• If the equilibrium HK dollar interest rate is higher than the
equilibrium US dollar rate, the supply of loanable funds in
Hong Kong will rise as investors shift their portfolios
toward HK$ bonds. (If the equilibrium HK dollar bond
price is lower than the equilibrium US dollar bond,
demand for HK$ bonds will increase).
• If the equilibrium HK dollar interest rate is lower than the
equilibrium US dollar rate, the supply of loanable funds in
Hong Kong will fall as investors shift their portfolios
toward US$ bonds. (If the equilibrium HK dollar bond
price is higher than the equilibrium US dollar bond,
demand for HK$ bonds will increase).
HK$ Loanable Funds
US$ Loanable Funds
iUS
iS
iHK
iD
iD
iS
7
6
5
4
3
2
1
1999
2000
EFB
2001
TBILL
2002