MONEY & BANKING
Week 3: The behavior of Interest rates
Chapter 5
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Objectives



Introduce the theory of asset demand
Explain the determination of the
interest rate using Demand and supply
curves
Understand factors affecting
movements in interest rates:


Factors create a shift in demand curve
Factors create a shift in supply curve
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Determinants of asset demand

Determinants of asset demand



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Wealth: the total resources, including all assets
Expected return: (for the next period) on one
asset, compared to alternative assets.
Risk: 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, compared to alternative
assets
.
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Determinants of asset demand
Wealth:
 When the wealth increases (more
resources to spend), higher demand for
assets, more quantity of assets
demanded.
 Holding everything else constant, an
increase in wealth raised the quantity
demanded of an asset.
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Determinants of asset demand
Expected returns
 Holding everything else constant, an
increase in an asset’s expected return
relative to that of an alternative asset
raises the quantity demanded of the
asset.
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Determinants of asset demand
Risk
 Holding everything else unchanged, if
an asset’s risk rises relative to that of
alternative assets, its quantity
demanded will fall.
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Determinants of asset demand
Liquidity
 Holding everything else constant, the
more liquid an asset is relative to
alternative assets, the more desirable it
is, and the greater will be the quantity
demanded.
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Theory of asset demand
Holding all of the other factors constant:
Variable
Wealth/Income
Expected return
(relative to other assets)
Risk
(relative to other assets)
Liqudity
(relative to other assets)
Change
in variable
Change in
quantity demanded Relationship
Increase
Increase
Positive
Increase
Increase
Positive
Increase
Decrease
Negative
Increase
Increase
Positive
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Loanable Funds Framework


Interest rates are determined by
demand for and supply of bonds.
(Demand and Supply curves)
Assumptions:


There is only one type of security (bond)
and a single interest rate in the economy
Except for the variable being analysed,
other economic variables are held constant
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Demand curve


Demand curve: shows the relationship
between the quantity demanded and
the price (other economic variables
constant)
A particular value of the interest rate
corresponds to each bond price.
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Demand curve
Discount bond
Price of
the bond
$950
$900
$850
$800
$750
Pays $1,000 face value in one year
Interest rate
5.30%
11.10%
17.60%
25.00%
33.30%
Quantity
demanded
$100 billion
$200 billion
$300 billion
$400 billion
$500 billion
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Supply curve

Supply curve: shows the relationship
between the quantity supplied and the
price of the bond (all other economic
variables constant)
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Supply curve
Discount bond
Price of
the bond
$950
$900
$850
$800
$750
Pays $1,000 face value in one year
Interest rate
5.30%
11.10%
17.60%
25.00%
33.30%
Quantity
supplied
$500 billion
$400 billion
$300 billion
$200 billion
$100 billion
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Market equilibrium



Market equilibrium: when the amount that
people are willing to buy (demand) equals the
amount that people are willing to sell (supply)
at a given price.
The given price is called equilibrium or
market-clearing price.
The interest rate corresponding to the
equilibrium price is called equilibrium or
market-clearing interest rate.
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Market equilibrium


Excess supply: occurs when the quantity of
bonds supplied exceeds the quantity of bonds
demanded.
Excess demand: occurs when the quantity of
bonds demanded exceeds the quantity of
bonds supplied.
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Changes in equilibrium
interest rates


Changes in interest rates: due to shifting
of demand and supplies curves
Shift in demand (supply) curve: occurs
when the quantity demanded (or
supplied) changes at each given price (or
interest rate) of the bond in response to a
change in some other factors besides the
bond’s price or interest rate
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Factors affecting the Demand for
Bonds
1.
2.
3.
4.
Wealth
Expected returns on bonds relative to
alternative assets
Risk of bonds relative to alternative
assets
Liquidity of bonds relative to alternative
assets
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1. Wealth
Wealth and business cycle:
In a business cycle expansion: wealth
increases, the demand for bonds rises,
demand curve for bonds shifts to the
right
In a recession, income and wealth are
falling, the demand for bonds falls, the
demand curve shifts to the left.

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1. Wealth
Wealth and propensity to save:
More savings, wealth increases, demand
for bonds rises, demand curve shifts to
the right.
Less savings, wealth falls, demand for
bonds falls, demand curve shifts to the
left.

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2. Expected returns
 Expected returns for long-term bonds:
Higher expected interest rates in the future,
lower the expected return for long-term
bonds, demand decreases, demand curve
shifts to the left.
And vice versa.
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2. Expected returns
Expected returns on other assets:
Higher expected returns on other alternative
assets shifts the demand curve for bonds
to the left.
An increase in the expected inflation rate
lowers the expected return for bonds,
demand curve for bonds shifts to the left.


Higher expected inflation rate, higher expected
returns on physical (real) assets (cars, houses),
lower expected returns on bonds.
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3. Risks
Risks:
Bonds become riskier, demand for bonds
falls, demand curve shifts to the left


Bond market more volatile
Alternative assets become riskier, demand
for bonds increase, demand curve shifts
to the right.
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4. Liquidity
Liquidity
Liquidity of bonds increases, increase in
demand for bonds, demand curve shifts
to the right
Liquidity of alternative assets increases,
decrease in demand for bonds, demand
curve for bonds shifts to the left.

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Factors affecting the Supply of
Bonds
1.
2.
3.
Expected profitability of investment
opportunities
Expected inflation
Government activities
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1. Expected profitability
Expected profitability
Business cycle expansion, higher expected
profitability of investment opportunities,
supply of bonds increases, supply curve
shifts to the right.
Recession, low expected profitability of
investment opportunities, supply of bonds
decreases, supply curve shifts to the left.

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2. Expected inflation rate
Expected inflation rate:
Higher expected inflation rate, real cost of
borrowing falls, supply of bonds
increases, supply curve shifts to the
right.

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3. Government activities
Government activities:
Increase in government deficits, supply of
government bonds increases, supply
curve shifts to the right.

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Changes in the interest rate:
further consideration

Changes in expected inflation: The
Fisher effect
Expected inflation rises, expected return on
bonds (compared to real asset) falls, demand
for bonds falls, demand curve for bonds shifts
to the left.
Expected inflation rises, real cost of borrowing
falls, supply of bonds increases, supply curve
for bonds shifts to the right.
Result: Equilibrium bond price falls. Equilibrium
interest rate rises.
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Changes in the interest rate:
further consideration

Changes in expected inflation: The
Fisher effect
When expected inflation rises, interest
rates will rise.
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Changes in the interest rate:
further consideration
Business cycle expansion:
Business cycle expansion, supply of bonds
increases, supply curve shifts to the
right.
Business cycle expansion, wealth
increases, demand for bonds increases,
demand curve shifts to the right.

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Changes in the interest rate:
further consideration
• Both demand and supply curves shift to
the right, new equilibrium price
(interest rate) moves to the right.
If supply curve shifts more than demand
curve, new equilibrium interest rate will
rise.
If supply curve shifts less than demand
curve, new equilibrium interest rate will
fall.
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Loanable funds framework:
Summary




Interest rates are determined by demand and
supply curves
Interest rates will changes when demand
and/or supply curves shift to the right or the
left.
Shift in the demand curve is due to changes
in wealth, expected return, risks or liquidity
Shift in the supply curve is due to profitability
of investment opportunities, real cost of
borrowing, or government activities.
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