The Behavior of Interest Rates

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The Behavior of Interest Rates
Chapter 5
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Nominal Interest Rates

• Nominal interest rates on 3-mo. Treasury Bills
  were about 1 in the fifties. In the eighties
  they were 15. At the end of 2000, they were
  above 6 in the middle of 2003, they were 1.
• What is the explanation for these interest rate
  fluctuations?
• The explanation for the nominal interest rate
  should apply to all nominal rates since interest
  rates usually move together.

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Determinants of Asset Demand

• The higher the wealth of an individual, the
  higher will be her demand for assets, both
  financial and real.
• The higher the expected return from an asset
  compared to other assets, the higher the demand
  for that asset.
• The riskier an asset is, the less there will be a
  demand for it.
• The more liquid an asset is, the higher the
  demand will be.

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Bond Price and Interest Rate

• Bond prices and interest rates are always
  inversely related.
• A discount bond that matures a year from now and
  priced at 900 carries an interest rate of
  (1000-900)/90011.1.
• A discount bond that matures a year from now and
  priced at 800 carries an interest rate of
  (1000-800)/80025.
• A console that pays 100 per year and sells for
  1000 carries an interest rate of 10.
• The same console when sold at 1250 carries an
  interest rate of 8.

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Demand for Bonds

• In boom times wealth (and income) rise. Demand
  for bonds will rise, too. During recessions
  demand for bonds will fall.
• If interest rates in the future are expected to
  fall, long-term bonds will have capital gains and
  increased returns, raising the demand for bonds.
• If the prices of bonds become more volatile, the
  demand for bonds will fall.
• If bonds became more liquid relative to other
  assets, the demand for bonds will increase.

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Measuring Demand for Bonds

• Typical demand curve would have price of bonds on
  the vertical axis and quantity of bonds on the
  horizontal axis.
• If bonds were the only form for funds to be
  raised, then those who demand to purchase bonds
  are the ones who supply funds.
• Demand for bonds is mirror image of supply of
  loanable funds.

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Bond Price and Interest Rate
P
i
i
P
800
25
11.1
900
900
11.1
25
800
Quantity of bonds
Loanable funds
An increase in the demand for bonds is the same
as an increase in the supply of loanable funds.

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Demand and Supply

• As the price of bonds falls, lender-savers will
  want to buy more demand is downward sloping.
• As the interest rate rises, lender-savers will
  want to supply more funds into the market supply
  of loanable funds is upward sloping.

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Demand and Supply

• As the price of bonds falls, borrower-investors
  will be more reluctant to issue bonds the supply
  of bonds will be upward sloping.
• As the interest rate rises, borrower-investors
  will be more reluctant to borrow demand for
  loanable funds will be downward sloping.

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Shifts in the Demand for Bonds

• Wealth in an expansion with growing wealth, the
  demand curve for bonds shifts to the right
• Expected Returns higher expected interest rates
  in the future lower the expected return for
  long-term bonds, shifting the demand curve to the
  left
• Expected Inflation an increase in the expected
  rate of inflations lowers the expected return for
  bonds, causing the demand curve to shift to the
  left
• Risk an increase in the riskiness of bonds
  causes the demand curve to shift to the left
• Liquidity increased liquidity of bonds results
  in the demand curve shifting right

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Supply of Bonds

• Increased confidence of producers means higher
  expected profits they tend to borrow more.
• Increase supply of bonds Increase demand for
  loanable funds
• A rise in the expected inflation, given nominal
  interest rates, would lower the cost of borrowing
  (real interest rate).
• Increase supply of bonds Increase demand for
  loanable funds
• Higher government deficits are financed by
  government borrowing.
• Increase supply of bonds Increase demand for
  loanable funds

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Impact on Interest Rates of a Sudden Increase in
the Volatility of Gold Prices
i
P
Gold becomes a riskier asset. Bonds become
relatively attractive. Demand for bonds
increases. Price of bonds rise and interest rate
falls.
P
P
Q of bonds
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Impact on Interest Rates When Real Estate Prices
Are Expected to Rise
The expected returns from real estate increases.
Bonds become less attractive demand drops. Price
of bonds fall and interest rates rise.
P
i
P
i
Quantity of bonds
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Impact on Interest Rates When Recession Occurs
During recessions, investment opportunities dry
up. Businesses scrap expansion plans. New bonds
are not issued. Supply of bonds falls. The
wealth effect of the recession will reduce
the demand for bonds, too. The net result is
increase in the price of bonds and decrease in
the interest rates.
P
i
P
i
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Business Cycle and Interest Rates
http//research.stlouisfed.org/fred2/graph/?idDTB
3,
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Impact on Interest Rates When Expected Inflation
Falls
P
When expected inflation falls, the expected
return on bonds rises bondholders expect capital
gains. Demand shifts to the right. On the other
hand, at a given nominal interest rate, the fall
in expected inflation raises the real interest
rate. The cost of borrowing increases, lowering
the supply of bonds. Price rises, interest rate
falls.
P
i
P
i
Q of bonds
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Expected Inflation and Interest Rates
(Three-Month Treasury Bills), 19532008
Source Expected inflation calculated using
procedures outlined in Frederic S. Mishkin, The
Real Interest Rate An Empirical Investigation,
Carnegie-Rochester Conference Series on Public
Policy 15 (1981) 151200. These procedures
involve estimating expected inflation as a
function of past interest rates, inflation, and
time trends.
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Japan

• Japan experienced a prolonged recession for two
  decades.
• Demand and supply of bonds both fell, raising the
  price of bonds and lowering the interest rate.
• Prolonged recession created deflation, making the
  expected return on real assets negative.
• Money (cash) became more desirable. Bonds less
  desirable than money but still preferable to real
  assets.
• Interest rates in Japan were close to zero.

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Response to a Business Cycle Expansion
If this depiction is true, what should we see
happen to interest rates?
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http//www.economist.com/finance/displaystory.cfm?
story_id8641615
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Impact on Interest Rates When U.S. Started To
Retire Long-Term Debt in 1999
i
The announcement that the Treasury will buy back
30-yr bonds raised the price of these bonds and
reduced the interest rate on these bonds. As a
result, the yield curve turned down at the
long-term maturity end.
P
P
i
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Impact of Low Savings on Interest Rates

• US personal savings rate (Personal income -
  Consumption) was at all time low in 1999-2000.
• Low savings imply shrinking of lender-saver
  funds.
• As loanable funds shrink the demand for bonds
  falls.
• The price of bonds falls and interest rate rises.

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Liquidity Preference Framework

• We have seen that interest rates can be
  determined using the equilibrium in the bond
  market or its mirror image, loanable funds
  market.
• Those who buy bonds are the ones who loan funds
  and those who sell bonds are the ones who borrow.
• If bonds and money are the two categories of
  assets people use to store wealth, then
  equilibrium in bond market will imply equilibrium
  in the market for money.

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How To Divide Assets Into Money and Bonds

• Money
• Currency
• Demand deposits

• Bonds
• Savings deposits
• Time deposits
• Bonds
• Stocks

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Equilibrium in Bond Market Equilibrium in Money
Market

• Total supply of wealth has to equal to total
  demand for wealth
• Ms Bs Md Bd
• If the bond market is in equilibrium, Bs Bd.
• Therefore, the market for money must be in
  equilibrium, Ms Md.

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Bond vs. Money Market

• Equilibrium in the bond market determines bond
  prices and interest rates, since each bond price
  is associated with a unique interest rate.
• Equilibrium in the market for money also
  determines the interest rate.
• The approaches are interchangeable, though the
  effects of some variable changes are easier to
  observe in one approach over the other.

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Liquidity Preference

• Why do people want to hold money?
• To conduct purchases for transaction purposes.
• Keynesian definition of money concentrates on the
  medium of exchange function and assumes that the
  return on money is zero.
• What makes people to hold more money?
• Income increases.
• Price level increases.
• Interest rate drops.
• Opportunity cost of holding money drops.

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Liquidity Preference Md

• The demand for money is drawn with interest rate
  on the vertical axis and quantity of money on the
  horizontal axis.
• The higher the interest rate, the higher is the
  opportunity cost of holding money, and the lower
  is the amount of money held.
• The demand for money becomes a downward sloping
  curve, a typical demand curve.
• Increases in income and/or the price level shift
  the curve to the right.

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Equilibrium in the Market for Money

• For the time being, we will assume that the
  supply of money is determined by the monetary
  authority, the central bank.
• Equilibrium between supply and demand for money
  takes place at a unique interest rate.
• If at a given interest rate, Md gt Ms, then people
  will sell bonds to convert them to cash. Bond
  prices will go down. Interest rates will go up,
  reducing Md.
• If MdltMs, people will convert money into bonds.
  The price of bonds will go up, lowering the
  interest rate until MdMs.

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Impact of an Increase In Income (Business Boom)
on Interest Rates
i
P
i
i
P
i
Q of bonds
M
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Impact on Interest Rates of an Increase in the
Price Level
P
i
i
M
Q of bonds
Price level increase forces people to hold more
money to make the same purchases. The adjustment
in the liquidity preference framework comes about
as people sell their bonds and keep cash. In the
bond market, the supply of bonds rises, lowering
the price and raising the interest rate.
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Impact on Interest Rates of an Increase in Ms
i
P
i
Q of bonds
M
In the liquidity preference framework, increase
in the money supply is shown by a rightward shift
of Ms. An excess of Ms over Md prompts people to
buy bonds and thus raise the price of bonds,
lowering the interest rate.
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Impact on Interest Rates of A Rise in Expected
Inflation
P
i
Q of bonds
M
An increase in the expected inflation will lower
the expected returns on bonds because interest
rates will rise forcing capital losses on
bonds. On the other hand, bond issuers will
expect to pay lower real interest rates in the
future and increase their supply. Prices of
bonds will fall and interest rates will rise. In
the liquidity preference framework,
the reluctance of bondholders to hold bonds
translates into an increase in the demand for
money and a rise in the interest rate.
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A Rise in the Money Supply May Not Lower Interest
Rates in The Long-Run

• Ms up gt i down (liquidity effect)
• i down gt I up gt Y up (income effect) gt Md up
• Y up gt P up (price level effect) gt Md up
• P up gt expected inflation up (expected inflation
  effect) gt Md up
• In the liquidity preference framework, income and
  price level effects will directly translate into
  a rightward shift of Md.

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Possible Outcomes

• If the liquidity effect is larger than the other
  effects, an increase in Ms will lower interest
  rates.
• If the liquidity effect is smaller than other
  effects but expectations adjust slowly, an
  increase in Ms will lower the interest rates
  initially but will raise them in the long run.
• If the liquidity effect is smaller than other
  effects and expectations adjust quickly, an
  increase in Ms will only bring an increase in
  interest rates.

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Quarterly Money Growth Rates and Short Term
Interest Rate
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Annual Money Growth Rates and Short Term Interest
Rate
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Annual Money Growth Rates and Short Term Interest
Rate