Chapter Four
BEHAVIOR OF INTEREST
RATES
Copyright © 2000 Addison Wesley Longman
Slide #4-1
Determinants of Asset Demand
Copyright © 2000 Addison Wesley Longman
Slide #4-2
Benefits of Diversification
1. Diversification almost always beneficial
to risk-averse investor
2. Less returns of securities move
together, greater is risk reduction from
diversification
Copyright © 2000 Addison Wesley Longman
Slide #4-3
Derivation of Demand Curve
i = RETe = (F - P)
P
Point A:
P = $950
i = ($1000 - $950) = .053 = 5.3%
$950
Bd = 100
Point B:
P = $900
i = ($1000 - $900) = .111 = 11.1%
$900
Bd = 200
Copyright © 2000 Addison Wesley Longman
Slide #4-4
Derivation of Demand Curve
Point C: P = $850 i = 17.6% Bd = 300
Point D: P = $800 i = 25.0% Bd = 400
Point E: P = $750 i = 33.0% Bd = 500
Demand Curve is Bd in Figure 1 which connects
points A, B, C, D, E.
Has usual downward slope
Copyright © 2000 Addison Wesley Longman
Slide #4-5
Supply
and
Demand
Analysis
of the
Bond
Market
Copyright © 2000 Addison Wesley Longman
Slide #4-6
Derivation of Supply Curve
Point F:
Point G:
Point C:
Point H:
Point I:
P = $750
P = $800
P = $850
P = $900
P = $950
i = 33.0%
i = 25.0%
i = 17.6%
i = 11.1%
i = 5.3%
Bs = 100
Bs = 200
Bs = 300
Bs = 400
Bs = 500
Supply Curve is Bs that connects points F, G, C,
H, I, and has upward slope
Copyright © 2000 Addison Wesley Longman
Slide #4-7
Market Equilibrium
1. Occurs when Bd = Bs, at P* = 850, i* =
17.6%
2. When P = $950, i = 5.3%, Bs > Bd
(excess supply): P  to P*, i  to i*
3. When P = $750, i = 33.0, Bd > Bs
(excess demand): P  to P*, i  to i*
Copyright © 2000 Addison Wesley Longman
Slide #4-8
Loanable Funds Terminology
1. Demand
for bonds
= supply
of
loanable
funds
2. Supply of
bonds =
demand
for
loanable
funds
Copyright © 2000 Addison Wesley Longman
Slide #4-9
Shifts in the Demand Curve
Copyright © 2000 Addison Wesley Longman
Slide #4-10
How Factors Shift the Demand
Curve
1. Wealth
A. Economy , wealth , Bd , Bd shifts out to right
2. Expected Return
(RETe)指現在的預期1年持有報酬率
指預期 A. i  in future, RETe for long-term bonds , Bd shifts out to
未來
right
YTM會
B. πe , relative RETe , Bd shifts out to right
下降
3. Risk
A. Risk of bonds , Bd , Bd shifts out to right
B. Risk of other assets , Bd , Bd shifts out to right
4. Liquidity
A. Liquidity of bonds , Bd , Bd shifts out to right
B. Liquidity of other assets , Bd ,Bd shifts out to right
Copyright © 2000 Addison Wesley Longman
Slide #4-11
Factors
that
Shift
Demand
Curve
Copyright © 2000 Addison Wesley Longman
Slide #4-12
Shifts in the Supply Curve
1. Profitability of
Investment
Opportunities
• Business cycle
expansion,
investment
opportunities ,
Bs , Bs shifts
out to right
2. Expected Inflation
• πe , Bs , Bs
shifts out to
right
3. Government
Activities
• Deficits , Bs ,
Bs shifts out to
right
Copyright © 2000 Addison Wesley Longman
Slide #4-13
Factors that Shift Supply Curve
Copyright © 2000 Addison Wesley Longman
Slide #4-14
Changes in π e: the Fisher Effect
If π e 
1. Relative
RETe ,
Bd shifts
in to left
2. Bs , Bs
shifts
out to
right
3. P , i 
Copyright © 2000 Addison Wesley Longman
Slide #4-15
Evidence on the Fisher
Effect in the United States
Copyright © 2000 Addison Wesley Longman
Slide #4-16
Business Cycle Expansion
1. Wealth , Bd
, Bd shifts
out to right
2. Investment
, Bs , Bs
shifts right
3. If Bs shifts
more than
Bd then P ,
i
Copyright © 2000 Addison Wesley Longman
Slide #4-17
Evidence on Business
Cycles and Interest Rates
不景氣
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Slide #4-18
Relation of Liquidity Preference
Framework to Loanable Funds
Keynes’s Major Assumption
Two categories of assets in wealth
1. money
2. bonds
1.
2.
3.
4.
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
Copyright © 2000 Addison Wesley Longman
Slide #4-19
Relation of Liquidity Preference
Framework to Loanable Funds
Money Market Equilibrium
5. Occurs when Md = Ms
6. Then Md - Ms = 0 which implies that Bd - Bs = 0,
so that Bd = Bs and bond market is also in
equilibrium
Copyright © 2000 Addison Wesley Longman
Slide #4-20
Relation of Liquidity Preference
Framework to Loanable Funds
1. Equating supply and demand for bonds in
loanable funds framework is equivalent to
equating supply and demand for money in
liquidity preference framework
2. Two frameworks are closely linked, but differ in
practice because liquidity preference assumes
only two assets, money and bonds, and
ignores effects from changes in expected
returns on real assets
Copyright © 2000 Addison Wesley Longman
Slide #4-21
Liquidity Preference Analysis
Derivation of Demand Curve
1. Keynes assumed money has i = 0
2. As i , relative RETe on money (equivalently,
opportunity cost of money )  Md 
3. Demand curve for money has usual downward
slope
Derivation of Supply curve
1. Assume that central bank controls Ms and is a
fixed amount
2. Ms curve is vertical line
Copyright © 2000 Addison Wesley Longman
Slide #4-22
Liquidity Preference Analysis
Market Equilibrium
1. Occurs when Md = Ms, at i* = 15%
2. If i = 25%, Ms > Md (excess supply): Price of
bonds , i  to i* = 15%
3. If i =5%, Md > Ms (excess demand): Price of
bonds , i  to i* = 15%
Copyright © 2000 Addison Wesley Longman
Slide #4-23
Money
Market
Equilibrium
Copyright © 2000 Addison Wesley Longman
Slide #4-24
Rise in Income
1. Income ,
Md , Md
shifts out
to right
2. Ms
unchanged
3. i* rises
from i1 to i2
Copyright © 2000 Addison Wesley Longman
Slide #4-25
Rise in Price Level
1. Price level
, Md , Md
shifts to
right
2. Ms
unchanged
3. i* rises
from i1 to i2
Copyright © 2000 Addison Wesley Longman
Slide #4-26
Rise in Money Supply
1. Ms , Ms
shifts out to
right
2. Md
unchanged
3. i* falls from
i1 to i2
Copyright © 2000 Addison Wesley Longman
Slide #4-27
Factors that Shift Money Demand
and Supply Curves
Copyright © 2000 Addison Wesley Longman
Slide #4-28
Money and Interest Rates
Effects of money on interest rates
1. Liquidity Effect
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 
4. Expected Inflation Effect
Ms , πe , Bd , Bs , Fisher effect, i 
Copyright © 2000 Addison Wesley Longman
Slide #4-29
Money and Interest Rates
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
Copyright © 2000 Addison Wesley Longman
Slide #4-30
Does
Higher
Money
Growth
Lower
Interest
Rates?
Copyright © 2000 Addison Wesley Longman
Slide #4-31
Evidence on Money Growth and
Interest Rates
Copyright © 2000 Addison Wesley Longman
Slide #4-32
Profiting from Interest-Rate
Forecasts
Methods for Forecasting
1. Loanable funds: use Flow of Funds Accounts and
judgement
2. Econometric Models: large in scale, use liquidity
preference
Make decisions about assets to hold
1. Forecast i , buy long bonds
2. Forecast i , buy short bonds
Make decisions about how to borrow
1. Forecast i , borrow short
2. Forecast i , borrow long
Copyright © 2000 Addison Wesley Longman
Slide #4-33
Supply and Demand in Gold
Market
Deriving Demand Curve
P  Pt
e
RET 
g
Pt
e
e
t 1
1. Pet+1 is held constant
2. Pt , ge , RETe   Gd 
3. Demand curve is downward sloping
Deriving Supply Curve
1. Pt , more production, Gs 
2. Supply curve is upward sloping
Copyright © 2000 Addison Wesley Longman
Slide #4-34
Supply and Demand in Gold
Market
Market Equilibrium
1. Gd = Gs
2. If Pt > P* = P1, Gs > Gd, Pt  to P*
3. If Pt < P* = P1, Gs < Gd, Pt  to P*
Copyright © 2000 Addison Wesley Longman
Slide #4-35
Changes in Equilibrium
Factors that Shift Demand Curve for Gold
1. Wealth
2. Expected return on gold relative to alternative
assets
3. Riskiness of gold relative to alternative assets
4. Liquidity of gold relative to alternative assets
Factors that Shift Supply Curve for Gold
1. Technology of mining
2. Government sales of gold
Copyright © 2000 Addison Wesley Longman
Slide #4-36
Response of Gold Market to a
If πe 
Change in πe
1. πe , Pet+1 ;
at given Pt,
ge   Gd 
 Gd shifts
right
2. Go to point
2; Pt 
3. Price of gold
positively
related to πe
4. Gold price is
barometer of
π-pressure
Copyright © 2000 Addison Wesley Longman
Slide #4-37