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Chapter4DeterminingInterestRates31
Chapter4
Determining Interest Rates
.1
Brief Chapter Summary and Learning Objectives
4.1
HowtoBuildanInvestmentPortfolio(pages8894)
Discussthemostimportantfactorsinbuildinganinvestmentportfolio.
Thedeterminantsofportfoliochoiceincludewealth,theexpectedrateofreturncomparedtoother
investments,degreeofriskcomparedtoalternatives,liquiditycomparedtootherassets,andthecost
ofacquiringinformationabouttheinvestmentrelativetootherinvestments.
Tocompensatefortheinabilitytofindaperfectasset,investorstypicallyholdvarioustypesofassets,
suchassharesofstockissuedbydifferentcompanies.
4.2
MarketInterestRatesandtheDemandandSupplyforBonds(pages94102)
Useamodelofdemandandsupplytodeterminemarketinterestratesforbonds.
Thedemandandsupplyofbondsdeterminesbondpricesandthustheirinterestrates.
Changesinthefollowingfactorswillcausethedemandcurveforbondstoshift:wealth,expected
returnsonbonds,risk,liquidity,andcostsofinformation.
Changesinthefollowingfactorswillcausesupplycurveforbondstoshift:theexpectedprofitability
ofphysicalcapitalinvestment,businesstaxes,expectedinflation,andgovernmentborrowing.
4.3
TheBondMarketModelandChangesinInterestRates(pages102107)
Usethebondmarketmodeltoexplainchangesininterestrates.
Anyfactorthataffectsthedemandorsupplyofbondsaffectsbondpricesandthusinterestrates.
4.4
TheLoanableFundsModelandtheInternationalCapitalMarket(pages107115)
Usetheloanablefundsmodeltoanalyzetheinternationalcapitalmarket.
Virtuallyalleconomiesinteractwiththerestoftheworldandareopeneconomies.
Inasmallopeneconomy,thedomesticrealinterestrateisdeterminedbytheinternationalcapital
market,sincethedomesticsupplyanddemandforfundsistoosmalltoaffecttheworldrealinterest
rate.
Alargeopeneconomyisaneconomythatislargeenoughtoaffecttheworldrealinterestrate.
.2
Key Terms and Concepts
ClosedeconomyAneconomyinwhich
households,firms,andgovernmentsdonot
borroworlendinternationally.
FishereffectTheassertionbyIrvingFisherthat
thenominalinterestrisesorfallspointforpoint
withchangesintheexpectedinflationrate.
DiversificationDividingwealthamongmany
Idiosyncratic(orunsystematic)riskRiskthat
2012PearsonEducation,Inc.PublishingasPrenticeHall
32Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition
differentassetstoreducerisk.
ExpectedreturnThereturnexpectedonan
assetduringafutureperiod;alsoknownas
expectedrateofreturn.
pertainstoaparticularassetratherthantothemarket
asawhole,aswhenthepriceofaparticularfirms
stockfluctuatesbecauseofthesuccessorfailure
ofanewproduct.
LargeopeneconomyAneconomyinwhich
shiftsindomesticsavingandinvestmentarelarge
enoughtoaffecttheworldrealinterestrate.
OpeneconomyAneconomyinwhichhouseholds,
firms,andgovernmentsborrowandlend
internationally.
Market(orsystematic)riskRiskthatis
commontoallassetsofacertaintype,suchasthe
increasesanddecreasesinstocksresultingfrom
thebusinesscycle.
RiskThedegreeofuncertaintyinthereturnon
anasset.
SmallopeneconomyAneconomyinwhichtotal
savingistoosmalltoaffecttheworldrealinterest
rate.
Chapter Outline
Ifinflationincreases,arebondsagoodinvestment?
Someinvestmentadvisorsinlate2009advisedclientstonottobuybondsbecauseofanticipatedinflationin
upcomingyears.
4.1
How to Build an Investment Portfolio (pages 8894)

LearningObjective:Discussthemostimportantfactorsinbuildinganinvestmentportfolio.
A. TheDeterminantsofPortfolioChoice
Thedeterminantsofportfoliochoiceincludewealth,theexpectedrateofreturncomparedtoother
investments,degreeofriskcomparedtoalternatives,liquiditycomparedtootherassets,andthecost
ofacquiringinformationabouttheinvestmentrelativetootherinvestments.
Anincreaseinwealthtendstoincreasethedemandformostfinancialassets.Demandforsomeassets,
suchasCDs,stocks,andbonds,arelikelytoincreasemore,whileotherassets,suchaschecking
accounts,increaseless.Peoplechoosetoacquireassetswithhigherexpectedratesofreturn.
Investorsneedtoconsiderpossiblereturnsandtheprobabilityofthosereturnsoccurringwhen
estimatingexpectedreturns.Riskisthedegreeofuncertaintyinthereturnofanasset.Mostinvestors
areriskaverseandwillchoosetoinvestinariskyassetonlyiftheyarecompensatedbyreceivinga
higherreturn.Asaresult,wetendtoviewatradeoffbetweenriskandreturn.Thegreateranassets
liquidity,themoredesirabletheassetistoinvestors.Thus,aninvestorwillbewillingtoreceivea
lowerreturnonaliquidassetcomparedtoanassetthatislessliquid.Investorsfindassetsmore
desirableiftheydonothavetospendtimeormoneyacquiringinformationaboutthem.Allelse
equal,investorswillacceptalowerreturnonanassetthathaslowercostsofacquiringinformation.
B. Diversification
Tocompensatefortheinabilitytofindaperfectasset,investorstypicallyholdvarioustypesof
assets,suchassharesofstockissuedbydifferentcompanies.Diversificationreducesidiosyncratic
risk,theriskassociatedwithaparticularasset.Muchoftheremainingriskismarketorsystematic
risk,riskthatiscommontoallassetsofacertaintype.
Teaching tips
InMakingtheConnection:FeartheBlackSwan!onpages9091,theauthorsintroducetheconceptofa
BlackSwaneventthatwasdevelopedbyNassimTaleb,professionalinvestorandprofessoratNewYork
University.Thebasicideaofablackswanisthat,occasionally,thereareuniqueeventsthattakeplace(more
oftenthanpeoplethink)thathaveasignificantlyadverseeffectonreturns.InanarticletitledPreparingfor
theNextBlackSwanintheWallStreetJournal(August21,2010),pointsoutthatdiversificationmaynotbe
sufficientinreducingriskwhenthereareBlackSwanevents.Forexample,duringthefinancialcrisisinlate2008,
virtuallyallassetclassesdeclinedinvalueatthesametime.Insteadofrelyingononlydiversification,
investorsmayinsteadwanttomakeuseofvariousformsofderivativestoprepareforBlackSwans.However,
thereisnofreelunch,sincetherearecostsinvolvedinpurchasingderivativeswhiletheymayonlybe
exercisedonrareoccasions.ThistopicwillbeexploredfurtherinChapter7.
4.2
Market Interest Rates and the Demand and Supply for Bonds (pages 94102)
LearningObjective:Useamodelofdemandandsupplytodeterminemarketinterestratesforbonds.
A. ADemandandSupplyGraphoftheBondMarket
Thedemandcurveforbondsrepresentstherelationshipbetweenthepriceofbondsandthequantity
ofbondsdemandedbyinvestors,holdingconstantallotherfactors.Asthepriceofbondsincreases,
theirinterestratesfallandtheybecomelessdesirabletoinvestors,sothequantitydemandedwill
decline,resultinginadownwardslopingdemandcurve.Thesupplycurverepresentstherelationship
betweenthesupplyofbondsandquantityofbondssuppliedbyinvestorswhoownexistingbondsand
byfirmsthatareconsideringissuingnewbonds.Asthepriceofbondsincreases,theirinterestrates
willfallandholdersofexistingbondswillbemoreinclinedtosellthem,resultinginanupwardsloping
supplycurve.Anexcesssupplyofbondsleadstoalowerbondpriceand,therefore,ahigherinterest
rate,whereasanexcessdemandforbondsleadstoahigherbondpriceandalowerinterestrate.
B. ExplainingChangesinEquilibriumInterestRates
Thedemandandsupplycurvesforbondsheldconstanteverythingthatcouldaffectthewillingness
ofinvestorstobuybonds,orfirmsandinvestorstosellbonds,exceptforthepriceofbonds.Ifany
otherrelevantvariablesuchaswealthortheexpectedrateofinflationchanges,thenthedemand
(orsupply)curveshiftsandwehaveachangeindemand(orsupply).
C. FactorsthatShifttheDemandCurveforBonds
Anincreaseinwealthincreasesthedemandforbonds.Iftheexpectedreturnonbondsrises,relative
toexpectedreturnsonotherassets,theninvestorswillincreasetheirdemandforbondsandthedemand
curveforbondswillshifttotheright.Ifexpectedinflationincreases,theexpectedrealinterestrate
willdecline,reducingthedemandforbonds.Anincreaseintheriskofbonds,relativetotheriskness
ofotherassets,decreasesthewillingnessofinvestorstobuybondsandcausesthedemandcurvefor
bondstoshifttotheleft.Iftheliquidityofbondsincreases,investorsdemandmorebondsatany
givenpriceandthedemandcurveforbondsshiftstotheright.Lowerinformationcostsforbonds
causesthedemandcurveforbondstoshifttotheright.
Teachings Tips
Inthespringof2010,therewasconsiderableconcernaboutapossiblesovereigndebtcrisisinEurope,with
particularattentionpaidtoGreece,Portugal,andSpain.Havestudentsdiscusstheresponseofglobalinvestors
tothiscrisis.BesuretoindicatehowglobalinvestorsfledtothesafetyofU.S.Treasurybonds,resultingina
declineininterestratesonU.S.governmentbonds.
D. FactorsThatShifttheSupplyCurveforBonds
Anincreaseinfirmsexpectationsoftheprofitabilityofinvestmentsinphysicalcapitalwill,holding
allotherfactorsconstant,shiftthesupplycurveforbondstotherightasfirmsseektofinancenew
investment.Whenbusinesstaxesareraised,theprofitsfirmsearnonnewinvestmentsinphysical
capitaldecline,andfirmsissuefewerbonds,causingthesupplyofbondstoshifttotheleft.An
increaseintheexpectedinflationrateresultsinadeclineintherealinterestrates,causingthesupply
curveofbondstoshifttotheright.Ifthegovernmentrunsalargerbudgetdeficit,itwillneedto
issuemorebonds,causingthesupplyofbondstoshifttotheright.Ifthegovernmentrunsadeficit,
householdsmaysavemoreinanticipationofhigherfuturetaxpayments,causingthedemandfor
bondstoshifttotheright.However,studiesindicatethathouseholdsdonotincreasetheirsavingby
thefullamountofthebudgetdeficit,thus,allelseequal,bondpricesarelikelytodeclineand
interestratesincrease.
Teachings Tips
Encouragestudentstospendsometimereviewingthefollowingtables:
Table4.2,FactorsthatShifttheDemandCurveforBonds,onpage99.
Table4.3,FactorsthatShifttheSupplyCurveforBonds,onpage103.
4.3
The Bond Market Model and Changes in Interest Rates (pages 102107)
LearningObjective:Usethebondmarketmodeltoexplainchangesininterestrates.
A. WhyDoInterestRatesFallDuringRecessions?
Duringrecessions,wealthdeclinesasdoestheexpectedprofitabilityofinvestments.Thedeclinein
wealthshiftsthedemandforbondstotheleft,puttingdownwardpressureonbondprices,whilethe
declineintheexpectedprofitabilityofinvestmentcausesthesupplyofbondstoshifttotheleft,
puttingupwardpressureonprices.EvidencefromU.S.datashowsthatinterestratesdeclineduring
recessions,indicatingthatsupplydeclinesmorethandemand,resultinginhigherbondprices.
B. HowDoChangesinExpectedInflationAffectInterestRates?TheFisherEffect
Higherexpectationsofinflationreducetheexpectedrealinterestrate,leadingtoanincreaseinthe
supplyofbondsandadecreaseinthedemandforbonds.Asaresult,thebondpricedeclinesandthe
interestrateincreases.ThissupportstheFisherEffect,whichstatesthatthenominalinterestrate
increasesoneforonewithchangesinexpectedinflation.Economistshavefoundthatvariousreal
worldfrictionsresultinnominalinterestratesnotalwaysincreasingordecreasingbyexactlythe
amountofachangeinexpectedinflation.
4.4
The Loanable Funds Model and the International Capital Market (pages 107115)
LearningObjective:Usetheloanablefundsmodeltoanalyzetheinternationalcapitalmarket.
A. TheDemandandSupplyforLoanableFunds
Thedemandcurveforloanablefunds,whichshowstherelationshipbetweenthequantitydemanded
forloanablefundsandtheinterestrate,isequaltothesupplyofbonds.Thesupplycurvefor
loanablefunds,whichrelatesthequantityofloanablefundssuppliedtotheinterestrate,isequalto
thedemandforbonds.
B. EquilibriumintheBondMarketfromtheLoanableFundsPerspective
Anyofthefactorsthatthatcausethedemandcurveforbondstoshiftwillcausethesupplycurvefor
loanablefundstoshift.Similarly,anyofthefactorsthatcausethesupplycurveforbondstoshift
willcausethedemandcurveforloanablefundstoshift.Interestrateswilladjusttoensurethatthe
quantitydemandedforloanablefundsequalsthequantitysuppliedofloanablefunds.
C. TheInternationalCapitalMarketandtheInterestRate
Nearlyalleconomiesareopeneconomies,wherefinancialcapital,orloanablefunds,ismobile
internationally.Borrowingandlendingtakesplaceintheinternationalcapitalmarket,whichisthe
capitalmarketinwhichhouseholds,firms,andgovernmentsborrowandlendacrossnationalborders.
Theworldrealinterestrateistheinterestratethatisdeterminedintheinternationalcapitalmarket.
Aclosedeconomyisaneconomythathasnointeractionintermsoftradeorfinancewithother
countries,whichisextremelyrareintodaysworld.
D. SmallOpenEconomy
Inthecaseofasmallopeneconomy,thequantityofloanablefundssuppliedordemandedistoo
smalltoaffecttheworldrealinterestrate.So,asmallopeneconomysdomesticrealinterestrate
equalstheworldrealinterestrateasdeterminedintheinternationalcapitalmarket.Ifthequantityof
loanablefundssupplieddomesticallyexceedsthequantityoffundsdemandeddomesticallyatthat
interestrate,thecountryinvestssomeofitsloanablefundsabroad.Ifthequantityofloanablefunds
demandeddomesticallyexceedsthequantityoffundssupplieddomesticallyatthatinterestrate,the
countryfinancessomeofitsdomesticborrowingneedswithfundsfromabroad.
E. LargeOpenEconomy
Alargeopeneconomyisaneconomythatislargeenoughtoaffecttheworldrealinterestrate.The
interestratewilladjustuntiltheexcesssupply(demand)ofloanablefundsfromthelargeopeneconomy
equalstheexcessdemand(supply)forloanablefundsintherestoftheworld,resultinginthedomestic
realinterestrateequalingtheworldrealinterestrate.Factorsthatcausethedemandandsupplyof
fundstoshiftinalargeopeneconomywillaffectnotjusttheinterestrateinthateconomy,butthe
worldrealinterestrateaswell.
Teaching Tips
Foryears,theUnitedStateshasexperiencedhugenetcapitalinflows.Somepeopleareconcernedabout
borrowingfromabroad.HavestudentsdiscusswhatwouldhappentorealinterestratesintheUnitedStatesif
werestrictedborrowingfromoverseas(i.e.,iftheUnitedStatesbecameamoreclosedeconomy).
.1
Solutions to the End-of-Chapter Questions and Problems
Answers to Thinking Critically Questions

1.
TheFishereffectstatesthatthenominalinterestraterisespointforpointwiththeexpectedrateof
inflation.TheFishereffectimpliesthatchangesinexpectedinflationcanleadtochangesinnominal
interestratesbeforeachangeininflationhasoccurred.BillGrossfromtheinvestmentfirmPimcocited
inflationaryexpectations,aswellasanincreaseinthesupplyofTreasurybonds,asreasonsforinterest
rateincreases:
Besidestheinflationfearssetoffbythestrengtheningeconomy,Mr.Grosssaidhewasalso
waryofTreasurybondsbecausehefearedtheburgeoningsupplyofnewdebtissuedtofinance
thegovernmentshugebudgetdeficitswouldoverwhelmdemand,drivinginterestrates
higher....
2.
TheU.S.inflationrateinthelate1970sreacheddoubledigitlevels,whichmadeinflationthenations
numberoneeconomicproblem.AfterPaulVolckerwasnamedchairmanoftheFederalReserveBoardin
August1979,theFedbegantoreducethegrowthofthemoneysupply.Thecombinationofhigh
inflationaryexpectationsandtightmonetarypolicydroveinterestratestoveryhighlevels.Asaresult,
theUnitedStatessufferedfromarecessionthatbeganinAugust1981andendedinNovember1982.As
theeconomycontracted,inflationaryexpectationsandinterestratesdeclined.
4.1 How to Build an Investment Portfolio

Learningobjective:Discussthemostimportantfactorsinbuildinganinvestmentportfolio.
Review Questions
1.1
Aportfolioisacollectionofinvestmentsheldbyaninstitutionorprivateindividual.
1.2
Therearefivedeterminants:1)Theamountofwealthasaverhas,2)theexpectedrateofreturn
comparedtoalternativeinvestments,3)thecomparativedegreeofrisk,4)thecomparativedegreeof
liquidity,and5)thecomparativedegreeofthecostofacquiringinformationabouttheinvestment.
1.3
Expectedreturnisthereturnexpectedonanassetduringafutureperiod.Riskisthedegreeof
uncertaintyinthereturnonanasset.
1.4
Riskaversereferstoinvestorswhohaveanaversiontorisk,meaningthatwhenchoosingbetween
twoassetswiththesameexpectedreturnsriskaverseinvestorswouldchoosetheassetwiththe
lowerrisk.Mostinvestorsareriskaverse.
1.5
Thehighertheriskthatanassethas,thelowerthedemandfortheasset,whichraisestheyieldor
return.Lowriskassetshaveahighdemand,whichlowerstheiryieldorreturn.
1.6
Marketriskistheriskthatiscommontoallassetsofacertaintypebecauseofsharedeconomic
conditions.Idiosyncraticriskistheriskthatpertainstoaparticularasset,suchasanindividual
stock,ratherthantothemarketasawhole.
1.7
Diversificationistheprocessbywhichindividualsorfirmsallocatesavingsamongmanydifferent
assets.Diversificationreducesriskbecauseindividualsandfirmshaveavarietyofdifferentasset
classes,soifoneclass(saybonds)performspoorlytherestoftheportfoliomayperformwell.
Problems and Applications

1.8
GooglefoundersPageandBrinwerereducingtheamountofidiosyncraticriskintheirportfoliosby
reducingtheirholdingsofGooglestockandpurchasingotherassetstoincreasediversificationand
liquidity.
1.9
Ablackswaneventisaneventthathappensveryrarelythathasalargeimpactonsociety.Black
swaneventsarehardtopredictbecausethelikelihoodofthemhappeningisstatisticallyverylow.
Someconsiderthefinancialcrisisof20072009ablackswanevent.
1.10
Theprimarytradeoffisbetweenriskandreward.Generallythemoreriskanassethas,thehigher
thereturnitprovides.Forinstance,ahighyieldingcorporatebondprobablyhasahighyield
becauseoftheriskofdefault.However,ifthecompanystayssolventthentherewardisveryhigh.
Agovernmentbondhasaverylowriskofdefault,butalsohasarelativelyloweryield.
1.11
Youngpeopleshouldallocatethemajorityoftheirportfoliotoequitiesbecauseofthegreaterrateof
returnoverthelongrun.Asinvestorsgetolder,theirportfolioshouldswitchtolessriskyassetssuch
astreasurybonds.
4.2 Market Interest Rates and the Demand and Supply for Bonds
Learningobjective:Useamodelofdemandandsupplytodeterminemarketinterestratesforbonds.
Review Questions
2.1
a. Thedemandcurveforbondswouldshifttotheleftbecause:
1. wealthdecreases,
2. expectedreturnsonbondsrelativetootherassetsdecreases,
3. expectedinflationincreases,
4. riskonbondsrelativetootherassetsincreases,
5. liquiditydecreases,or
6. costsofinformationincreases.
b. Thesupplycurveforbondswouldshifttotherightbecause:
1. expectedprofitabilityincreases,
2. corporatetaxratesdecrease,
3. subsidiestobusinessincrease,
4. expectedinflationrises,or
5. governmentborrowingincreases.
2.2
Thebonddemandcurveslopesdownbecauseasthepriceofbondsdecreases,theinterestrateson
thebondswillrise,andthebondswillbecomemoredesirabletoinvestors,sothequantitydemanded
willrise.Thebondsupplycurveslopesupbecauseasthepriceofbondsdecreases,theirinterest
rateswillrise,andholdersofexistingbondswillbelesswillingtosellthem.Also,firmswillfindit
moreexpensivetoborrowatthehigherinterestrateandwillissuefewerbonds.Forbothofthese
reasons,thequantityofbondssuppliedwilldecrease.
2.3
Theexcesssupplyofbondscausesthepriceofbondstofall,increasingquantitydemandedand
reducingquantitysupplied.Thereisnoshiftinthesupplyordemandcurve.
2.4
a. False:thequantitydemandedofbondsfalls.
b. True:Thelowertheprice,thehighertheyield,whichincreasesthecostofborrowing.
c. True:Ashifttotherightinthedemandcurvewillpushbondpricesupandyieldsdown.
d. False:ThiswouldcauseashifttotheleftofthedemandforU.S.governmentbonds,pushingprice
downandyieldup.

2.5
a.
b.
c.
d.
e.
Demandcurveshiftsleft,supplyofbondsshiftsright.
Supplycurveshiftsright.
Supplycurveshiftsleft.
Demandcurveshiftsleft.
Demandcurveshiftsleft,supplycurveshiftsleft.
2.6
a. Theactualrealrateofinterestcanbecomenegativeiftheactualinflationratesufficientlyexceeds
theexpectedinflationrate.
b. Duringthe1970s,theinflationrateunexpectedlyrosetodoubledigits,leadingtonegativeactual
realinterestrates.
2.7
a. Supplycurveshiftsright,reducingthepriceofbondsandincreasingtheequilibriumquantityofbonds.
b. Thedemandcurveshiftstotheright,increasingthepriceofbondsandincreasingtheequilibrium
quantityofbonds.
c. Thesupplyofbondsshiftstotherightandthedemandforbondsshiftstotheright.Thisincreases
theequilibriumquantityofbonds,butthechangeinthepriceofbondsisindeterminant.
2.8
Thesupplycurvewouldshifttotheleft,raisingbondpricesandloweringbondyields.
2.9
Theprofitablebusinessopportunitieswouldincreasethesupplyforbondsandtheincreaseinstock
priceswouldlowerthecomparativereturnonbonds,decreasingthedemandforbonds.Asshownin
thegraphbelow,thepriceofbondswouldfall,buttheequilibriumquantitywouldbeindeterminate.
4.3 The Bond Market Model and Changes in Interest Rates

Learningobjective:Usethebondmarketmodeltoexplainchangesininterestrates.
Review Questions
3.1
Interestratesfallduringrecessions.Asthegraphbelowshows,thedemandforbondsdecreasessince
householdsexperiencedecliningwealth,andthesupplyofbondsdecreasessincebusinesseshave
fewerprofitableopportunitiesduringarecession.Forinterestratestofall,thepriceofbondsmust
rise,sothedecreaseinthesupplyforbondsmustexceedinmagnitudethedecreaseinthedemand
forbonds.
3.2
AccordingtotheFishereffect,thenominalinterestraterisesorfallspointforpointwithchangesin
theexpectedinflationrate.Asthegraphbelowshows,anincreaseinexpectedinflationdecreasesbond
demandandincreasesbondsupply,decreasingbondpricesandincreasingbondyields(interestrates).

3.3
a. Demandwillshiftrightandsupplywillshiftleft.Thepriceincreases,andbutitisunclearwhat
happenstotheequilibriumquantityofbonds.
b. Thedemandforbondsshiftsrightwiththeincreaseinwealthfromtheexpansionandthesupplyfor
bondsshiftsrightwiththeincreaseinprofitableopportunities.Duringeconomicexpansionsinterest
ratestypicallyrise,sothepriceofbondsmustfall,implyingthattheincreaseinthesupplyforbonds
exceedstheincreaseinthedemandforbonds.Theequilibriumquantityofbondsincreases.
c. Supplyofbondsshiftstorightandthedemandforbondsshiftsleft.Thepriceofbondsfalls,butitis
unclearwhathappenstotheequilibriumquantityofbonds.
d. Thesupplyofbondsincreasesshiftingthesupplycurvetotheright,forcingpricesdownandthe
quantityup.
3.4
a. ItwasunclearwhethertheGreekgovernmentwasgoingtobeabletocontinuetofinanceitslarge
budgetdeficits.
b. ThedemandforbondswasfallingdrasticallybecauseoftheriskofGreecedefaultingonitsdebt.
c. ThelargeGreecebudgetdeficitsincreasedbondsupplyandtheincreasingriskofdefaultdecreased
bonddemand,decreasingbondpricesandincreasingyields.
3.5
a. Deflationisafallintheaggregatepricelevel.
b. Whencalculatingtherealinterestrate,deflationincreasestheyieldonbonds.
3.6
3.7
Anincreaseinexpectedinflationwouldshiftthedemandforbondstotheleftandthesupplyfor
bondstotheright,pushingpricesdownandyieldsup.Longertermbondswouldbemoreatrisk
becauseinflationisexpectedtoincreaseoverextendedperiodsoftimebecauseofFederalReserve
policyduringthefinancialcrisis,foragivenchangeininterestrateslongtermbondpricesaremore
affectedthanshorttermbondprices.
a. Bondpriceswillfallandinterestrateswillrise.
b. Investorswhoboughtlongtermtreasurybondswillbenefitbecausethepricewillnotfallas
anticipated,meaningownersofthesebondswillmakeahigheryield.
4.4 The Loanable Funds Approach and the International Capital Market
Learningobjective:Usetheloanablefundsmodeltoanalyzetheinternationalcapitalmarket.
Review Questions
4.1
a. BondMarket:Thegoodisthebond.LoanableFunds:Thegoodistheuseoffunds.
b. BondMarket:Thebuyeristhebondholder(thesaver/investor).LoanableFunds:Thebuyeristhe
borrower.
c. BondMarket:Theselleristheborrower(agovernmentoracorporation).LoanableFunds:
Theseller(supplycurve)isthesaver.
d. BondMarket:Thepriceisthepriceofthebond.LoanableFunds:Thepriceistheinterestrate.
4.2
Thedemandcurveisdownwardslopingbecausethehighertheinterestrate,thelessdemandfor
borrowingbecausethecostishigher.Thesupplycurveisupwardslopingbecausethehigherthe
interestratethemorewillingsuppliersofloanablefundswillbetolendmoney.
4.3
Thebondmarketapproachismostusefulwhenconsideringhowthefactorsaffectingthedemand
andsupplyforbondsaffecttheinterestrate.Theloanablefundapproachismostusefulwhen
lookingattheflowoffundsbetweentheU.S.andforeignfinancialmarkets.
4.4
a. Aclosedeconomyisaneconomywherehouseholds,firms,andgovernmentsdonotborroworlend
internationally.
b. Smallopeneconomy:Aneconomywherethequantityofloanablefundssuppliedordemandedistoo
smalltoaffecttheworldrealinterestrate.Itisalsoassumedthatfinancialcapitalmovesinternationally.
c. Alargeopeneconomyisaneconomythatislargeenoughtoaffecttheworldinterestrateand
assumesthatcapitalmovesinternationally.
d. Theworldrealinterestrateistheinteretratethatisdeterminedintheinternationalcapitalmarketthat
equatestheworldquantitydemandedofloanablefundstotheworldquantitysuppliedofloanablefunds.

4.5
a. Asshowninthegraphbelow,thedemandcurveforloanablefundsshiftsright,raisingtheworldreal
interestrate.
b. Thesupplycurveforloanablefundswouldalsoshiftright.Theinterestratewouldfallfromits
previouspointinpartatoanundeterminedpoint,dependingonhowmuchhouseholdsincreased
theirsaving.Seethegraphbelow.
4.6
Asshowninthegraphbelow,thedemandcurveforloanablefundsintheUnitedStatesshiftstothe
left,whichlowerssomewhattheworldrealinterestrate.Thiswouldcauseanexcesssupplyof
loanablefundsintheU.S.,whichwouldmaketheU.S.anetinternationallender.
4.7
a. Nochangeinworldinterestrate.Sinceasmallopeneconomyhasthesameinterestrateastheworld
interestrate,therewouldbenochangeinthedomesticinterestrate.
b. Nochangeintheinterestrate.
c. Thesupplyofloanablefundsworldwideshiftstotheright,reducinginterestrates.
d. Nochangeinworldinterestrate.
4.8
a. Demandforloanablefundsincreases,increasinginterestrates.
b. Demandforloanablefundsdecreases,decreasinginterestrates.
c. Supplyofloanablefundsincreases,decreasinginterestrates.
d. Supplyofloanablefundsdecreases,increasinginterestrates.
4.9
a. Netexpectedprofitabilityfalls,sothedemandforloanablefundsfalls.
b. Expectedprofitabilityrises,sothedemandforloanablefundsrises.
c. Theincreaseintheexpectedaftertaxinterestratereducesthedemandforloanablefunds.
4.10 a. ThetreasurymarketisthemarketforU.S.Treasurybonds.
b. Iftherewerepanic,peoplewouldsellTreasurybondspushingpricesdown,andtheyieldup.The
authornotesthatyieldshavenotrisen,whichmeanstherehasnotbeenaselloffofTreasurybonds.
4.11 a. Inthegraphbelow,beginwiththeworldrealinterestrateequalto3%andtherestoftheworldasa
netinternationallenderandtheU.S.asanetinternationalborrower.Anincreaseinsavingintherest
oftheworldshiftsthesupplyofloanablefundsintherestoftheworldtotheright,loweringtheworld
realinterestrateto1%.Withtheincreasedsaving,therestoftheworldbecomesmoreofaninternational
lender,andwiththelowerworldrealinterestratetheU.S.becomesmoreofaninternationalborrower.
b. ThereisadebateoverwhethertheFederalReservewasresponsibleforlowinterestratesorwhether
theglobalsavingsglutwasresponsible.Iftheglobalsavingsglutwasresponsible,wecouldargue
thattheFederalReserveshouldtakelessblamefortheartificiallylowinterestratesthathelped
facilitatethehousingbubble.
Data Exercises
D4.1
Thepeakyieldoverthe5yearperiodwas5.11inMayandJuneof2006.Thelowestyieldwasat
2.42inDecemberof2008.Bondyieldsfellfrompeaktotroughbecauseofinvestorsflighttosafety.
InatimeofpanicU.S.Treasurybondsarethesafestassetintheworld.Thedemandcurveshiftsto
theright,pushingpricesupandyieldsdown.
D4.2
Assumingtheinvestorholdstomaturity,1981wouldhavebeenthebestyeartobuyabond.

M04 Hubb3538 1e Im C04

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Chapter4DeterminingInterestRates31

Brief Chapter Summary and Learning Objectives

Key Terms and Concepts

How to Build an Investment Portfolio (pages 8894)

Solutions to the End-of-Chapter Questions and Problems

Answers to Thinking Critically Questions

4.1 How to Build an Investment Portfolio

Problems and Applications

Problems and Applications

4.3 The Bond Market Model and Changes in Interest Rates

Problems and Applications

Problems and Applications

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