FNCE 3020
Financial Markets and Institutions
Fall Semester 2005
Lecture 3
The Behavior of Interest Rates
How Might We Examine How Interest
Rates Behave?

Through the Loanable Funds Model
 Begin with Bond Market Model: i.e., demand
and supply analysis of bonds in the bond
market!


What happens to the quantity demand and quantity
supplied of bonds as we varying the price!
Then: Move from Bond Market Model to
Loanable Funds Model, where:


The Demand for bonds = supply of loanable funds
The Supply of bonds = demand for loanable funds
Determinants of Financial Asset
Demand

Facing the question of whether to buy and hold an asset or
whether to buy one asset rather than another, an individual must
consider the following factors:
1.
Wealth, the total resources owned by the individual, including
all assets held.
2.
Expected return (the return expected over the next period) on
one asset relative to alternative assets.
3.
Risk (the degree of uncertainty associated with the return) on
one asset relative to alternative assets.
4.
Liquidity (the ease and speed with which an asset can be
turned into cash) relative to alternative assets.
Changes in the Quantity Demanded

The quantity demanded of an asset differs according to:
1.
2.
3.
4.
Wealth: Holding everything else constant, an increase in
wealth raises the quantity demanded of an asset.
Expected return: An increase in an asset’s expected return
relative to that of an alternative asset, holding everything else
unchanged, raises the quantity demanded of the asset.
Risk: Holding everything else constant, if an asset’s risk rises
relative to that of alternative assets, its quantity demanded
will fall.
Liquidity: The more liquid an asset is relative to alternative
assets, holding everything else unchanged, the more desirable
it is, and the greater will be the quantity demanded.
Summary Table: Response of
Demand to Changes in Four Factors
Derivation of Demand Curve for
Bonds
Demand Curve: Shows the relationship between the
quantity demanded (for bonds) and the price of a bond,
when all other factors are held constant.
Demand for a 1 year discount bond can be show where
for a given price, the investment yield can be calculated
as follows (see investment yield formula, Lecture 2),
Where:
i = investment yield
FV  PP
Re = “expected return”
e
iR 
F = face value
PP
P = market price


Points Along the Bond Demand Curve

Demand for 1 year bond, assuming price of $950.


i = (1,000-950/950) = 5.3%
Assume at this price (and yield) 100 bonds will be
demanded.


Demand assuming price of $900


i = (1,000-900/900) = 11.1%
Assume at this price (and yield) 200 bonds will be
demanded


this will be point A on the demand schedule.
This will be point B on the demand schedule
Note: Market will hold more of the bond as its price
decreases (as expected yield increases).
Additional Points Along the 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

Demand Curve has a downward slope!

As the price of the bond decreases, demand for the bond
will increase (see movement along the x axis; next slide).

Why: As the price decreases, the yield increases!
Figure 1: Demand Curve (Bd)
Demand Curve is Bd
connecting points A, B,
C, D, E.
Has a downward slope.
As the price of the
bond decreases
(and the yield
increases), demand
(for bonds) will
increase (along the
x axis).
Derivation of the Supply Curve


Supply Curve: shows the relationship between the
quantity of a bond supplied and the price, when all other
factors are held constant.
Point F:
P = $750
i = 33.0%
Bs = 100
Point G:
P = $800
i = 25.0%
Bs = 200
Point C:
P = $850
i = 17.6%
Bs = 300
Point H:
P = $900
i = 11.1%
Bs = 400
Point I:
P = $950
i = 5.3%
Bs = 500
Supply Curve has upward slope!

As the price of the bond increases, supply will
increase (along the x axis).

Why: The yield (cost to borrow) decreases.
Figure 2: Supply Curve (Bs)
Supply Curve is Bs
that connects points
F, G, C, H, and I.
Has upward slope.
As the price of
the bond
increases (and
the yield
decreases),
supply (of bonds)
will increase
(along the x
axis).
Bond Market Equilibrium

Bond Market Equilibrium: occurs when the
amount of bonds an economy is willing to buy
(demand) equals the amount of bonds an
economy is willing to sell (supply).


Called the market-clearing price.
Bond Market disequilibrium (i.e., excess
demand or excess supply) is corrected
through price changes!
Restoring Market Equilibrium
1.
Occurs when Bd =
Bs, at P* = 850, i* =
17.6% (Point C)
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*
Shifts in the Bond Demand and Supply
Schedules

Up to this point, we have examined what will cause
a movement along (up or down) a bond demand
and bond supply curve.


Now we need to examine, what will cause either
schedule to shift (inward or outward)


There is only one factor: Changes in the price of the bond.
And in response to factors other than a change in the price
of the bond.
When one of the schedules changes, this produces
a change in the economy’s equilibrium interest rate.
Shifts in the Demand and Supply Curves

The analysis of interest rate behavior (i.e., changes in the market
equilibrium interest rate) needs to explore why the curves shift in or
out!
Factors Causing the Demand Schedule
to Shift Outward

Wealth: When the economy grows, wealth
increases. Increased wealth will result in a higher
demand for bonds (in investor portfolios).


During a business expansion, the demand for bonds will
increase.
Risk: If prices in the bond market become less
volatile (i.e., as the risk decreases), bonds will
become more attractive and the demand for bonds
will rise.

In addition, as alternative financial assets (e.g., stocks)
become more risky, the demand for bonds will rise.
Factors Causing the Demand Schedule
to Shift Outward

Expected Returns on Bonds: If the interest
rate is expected to be lower in the future
(than it is now), the demand for bonds will
increase now:


Why: If interest rates do fall in the future, the
prices of currently held bonds will rise.
In addition, if expected returns on alternative
financial assets falls (e.g., stocks), the demand for
bonds will increase
Factors Causing the Demand Schedule
to Shift

Liquidity: Increases in the liquidity of bonds
(marketability in secondary markets) will
cause bonds to be more attractive, and
increase the demand.


In addition, decreases in the liquidity of alternative
financial assets, causes the demand for bonds to
increase
Expected Rate of Inflation: Decreases in the
expected rate of inflation, will result in an
increase in the real return on bonds, and
cause the demand for bonds to increase.
Summary of Demand Factors
1.
Wealth

2.
Expected Return

3.

Risk of bonds , Bd shifts out to right
Risk of other assets , Bd shifts out to right
Liquidity


5.
Re for bonds (in the future) , Bd shifts out to the right.
Risk

4.
Wealth , Bd shifts out to right
Liquidity of bonds , Bd shifts out to right
Liquidity of other assets , Bd shifts out to right
Expected Inflation

πe , real return , Bd shifts out to right
Factors that Cause the Supply
Schedule to Shift Outward

Expected Profitability of Business Investment
Opportunities: The greater the expected
profit by business firms on their investments,
the more willing they are to borrow.


Increase borrowing = increase in the supply of
bonds.
Generally occurs during a business expansion.
Factors that Cause the Supply
Schedule to Shift Outward

Expected Inflation: When expected inflation
increases, the real cost of borrowing
decreases.



As the real cost of borrowing falls, firms increase
their borrowing.
Increase borrowing = increase in the supply of
bonds.
Government Policies: Higher government
deficits increases the need to borrow.

Increase borrowing = increase in the supply of
bonds.
Summary of Supply Factors
1.
Expected Profitability of Business Investment

2.
Profitability, Bs shifts out to right
Expected Inflation
πe , real cost of borrowing , Bs shifts out to right
3.
Government Policies

Government deficits , Bs shifts out to right
Adding the Rest of the World


Foreign sector activity can result in shifts in
another country’s demand and supply curves.
Assume the U.S. financial market:



Inward investment from overseas will shift the
demand schedule (for bonds) out.
Inward borrowing from overseas will shift the
supply schedule (for bonds) out.
Need to consider the impact of a global
financial market on changes in a country’s
equilibrium interest rate.
Loanable Funds Model


Defined: A framework whereby we analyze
the quantity of “loans” in the economy to
explain interest rate changes.
Loans = amount of funds supplied or
demanded.


Demand for bonds = supply of loanable funds
Supply of bonds = demand for loanable funds
Changes in the Market’s Equilibrium
Interest Rate

Decreasing rate results from either:



Increase in the demand for bonds (increase in the
supply of loanable funds)
Decrease in the supply of bonds (decrease in the
demand for loanable funds)
Increasing rate results from either:


Decrease in the demand for bonds (decrease in
the supply of loanable funds)
Increase in the supply of bonds (increase in the
demand for loanable funds)
Changes in the Equilibrium Interest
Rate: Rate Falling
Changes in the Equilibrium Interest
Rate: Rate Rising
Additional Considerations: The Fisher
Effect


Explanation of the market rate of interest.
States that the market rate of interest is the
sum of the real interest rate plus the
expected rate of inflation.


The desired real rate of interest reflects the rate of
real economic growth (i.e., the amount of reward
that should accrue to the lender for lending to a
productive economy).
An inflation premium is built in to nominal
interest rates protect against this loss of
purchasing power.
Changes in Market Interest Rates

Over time, changes in market interest rates may be
attributed to changes either in




the real desired rate 'r* or
due to changes in inflationary expectations.
Changes in the desired real rate reflects the
behavior in the market for loanable funds in
response to changing economic activity (real
economic activity).
Changes in inflationary expectations tends to be a
more complicated matter. One may hypothesize that
current inflationary expectations are based on the
history of past actual rates of inflation.

Called Adaptive Expectations model.
Evidence on the Fisher Effect in the
United States: 1953-2004
Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2004
Additional Consideration


However, at the time the debt contract is
priced the inflation premium is based on
expected rates of future inflation.
If these expectations differ from actual
inflation rates during the life of the debt
instrument either the lender or borrower can
be adversely affected.
Business Cycles and Short Term
Interest Rates: U.S.
Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2001
Note: Shaded areas are business contractions and white areas are business expansions
Business Cycles and Long Term Rates:
U.S.
Observations



Interest rates generally move in a “pro-cyclical” manner
(with variable lags). Generally we observe:
 Moving down in a business recession.
 Moving up in a business expansion.
Why?
 Business cycle impacts
 Central bank impacts
Note: Inflationary environment can affect the cyclical
move.
 1970s: High and rising inflationary expectations in
economy.
 1980s – 1990s: falling and eventually low inflationary
expectations in the economy.
Federal Funds Rate: 1955 - 1985
Federal Funds Rate: 1985 - Present
Example of Pro-Active Federal Funds
Rate Changes in Late 2000