8/17/2017

Topic 4
The Behavior of
Interest Rates
Instructor: Lai T. Hoang

Determinants of Asset Demand

An asset is a piece of property that is a
store of value. e.g. money, bonds,
stocks, art, land, houses, farm
equipment and manufacturing
machinery
What you consider when decide
whether to buy and hold an asset?

Determinants of Asset Demand

From financial perspective, there are four factors:
Wealth

Expected Return

Risk

Liquidity

1
 8/17/2017

Determinants of Asset Demand

Holding everything else constant,
The quantity demanded of an asset is ..
related to wealth.
The quantity demanded of an asset is ....related
to its expected return relative to alternative assets.
The quantity demanded of an asset is ..
related to the risk of its returns relative to alternative
assets.
The quantity demanded of an asset is .. related
to its liquidity relative to alternative assets.

Supply and Demand in the

Bond Market
At lower prices (higher interest rates),
ceteris paribus, the quantity demanded
of bonds is higher/lower?
The relationship between bond price
and quantity demanded of bonds should
be negative/positive?

Supply and Demand in the

Bond Market
At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is higher/lower?
The relationship between bond price
and the quantity supplied of bonds
should be negative/positive?

2
 8/17/2017

Supply and Demand for Bonds

Market Equilibrium
Occurs when the amount that people are willing to
buy (demand) equals the amount
that people are willing to sell (supply) at a given
price.
Bd = Bs defines the equilibrium (or market
clearing) price and interest rate.
When Bd > Bs , there is .. demand, price
will..and interest rate will .
When Bd < Bs , there is supply, price
will .. and interest rate will ..

Shift in the demand for bonds

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

3
 8/17/2017

Shift in the Demand Curve for

Bonds

10

Shift in the Supply of Bonds

Expected profitability of investment
opportunities: in an expansion, the supply
curve shifts to the .
Expected inflation: an increase in expected
inflation ... the real cost of funding for
firms and shifts the supply curve for bonds to
the ...
Government budget: increased budget deficits
shift the supply curve to the ..

Shift in the Supply Curve for

Bonds

12

4
 8/17/2017

Figure 4 Response to a
Change in Expected Inflation

13

Figure 5 Expected Inflation and Interest Rates

(Three-Month Treasury Bills), 19532011

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.

14

Business cycle expansion and

the interest rate
In a business cycle expansion, the nation income
rises and businesses are ............to borrow, because
there are ................ profitable investment
opportunities, hence the supply shifts to
the..............
As the economy expands, wealth ............. and the
demand for bond ................, hence the demand
shifts to the ..................

15

5
 8/17/2017

Response to a Business Cycle

Expansion

16

Business Cycle and Interest Rates (Three-

Month Treasury Bills), 19512011

17

Business cycle expansion and

the interest rate
In theory the interest rate can increase or
decrease depending on which shift is bigger.
However in reality the interest rate tends to
rise in business cycle expansion, indicating
the shift of .............. is dominant.

6
 8/17/2017

Liquidity Preference
Framework
Instead of determining the equilibrium interest
rate using the supply and demand for bonds, John
Maynard Keynes developed the liquidity preference
framework to analyze the interest rate in terms of
the supply and demand for money.

John Maynard Keynes

Note: The term market for money refers to the market for the medium of
exchange, money, rather than short-term debt instrument to be studied
in lecture 7 and 8.

Demand for Money in the Liquidity

Preference Framework
As the interest rate increases:
The opportunity cost of holding money

The relative expected return of money
and therefore the quantity demanded of
money ...
Thus, the demand curve should move
upward/downward?

Supply for money in the Liquidity

Preference Framework
Assume that central bank controls
money supply and it is a fixed amount.
=> Supply curve is a..line

7
 8/17/2017

Shifts in the Demand for

Money
In Keynes original analysis, two things would cause the demand
for money to change:
An Increase in Income/Wealth (Income Effect)
With more income, people would like to consume .. To increase
consumption, people need . money.
Money demand shifts .., causing interest rates to ..
An Increase in Prices (Price-level Effect)
With higher prices, the same quantity of money held buys .. goods
and services. To maintain consumption, people need to hold ..
money.
We can also consider several other factors that increase money
demand:
A/An .. in the risk of non-monetary assets (i.e. bonds)
A/an .. in the liquidity of non-monetary assets

Shifts in the Supply of Money

Assume that the supply of money is
controlled by the central bank
An increase in the money supply
engineered by the Federal Reserve will
shift the supply curve for money to the
right, and vice versa

Response to a Change in
Income or the Price Level

8
 8/17/2017

Response to a Change in the

Money Supply

Application: Does a Higher Rate of Growth

of the Money Supply Lower Interest
Rates?
Liquidity preference framework leads to the
conclusion that everything else remaining
equal, an increase in money supply
willinterest rates: the liquidity effect.
However, Noble prize winner Milton
Friedman argues that the increase in money
supply does not leave everything else
equal, but also affect income, price levels,
and expected inflation.
26

Application: Does a Higher Rate of Growth

of the Money Supply Lower Interest
Rates? (contd)
Income effect: increasing money
supply is an expansionary influence on
the economy, it should . national
income and wealth
Price-Level effect predicts an rise in the
money supply leads to a in
the price level, thus.interest
rates
27

9
 8/17/2017

Application: Does a Higher Rate of Growth

of the Money Supply Lower Interest
Rates? (contd)
Expected-Inflation effect: increase in
the money supply may lead people to
expect a .. price level in the
future, thus.interest rates
Whats the net effect on interest rate?

28

Scenario a

Liquidity effect dominates the other three effects.

Liquidity effect takes effect immediately to lower the
interest rate.
As time goes, price, income and expected-inflation effect
reverse some of the decline.
Interest rate settles at a . level.
29

Scenario b

Liquidity effect is smaller than the other three effects put

together and inflation expectation is adjusted slowly. Liquidity
effect takes effect immediately to lower the interest rate.
As time goes, price, income and expected-inflation effect
reverse the decline.
=> In the short run, interest rate . In the long run,
interest rate ends up ...

30

10
 8/17/2017

Scenario c

Liquidity effect is smaller than the other three effects put

together and inflation expectation is adjusted rapidly.
Expected-inflation effect operates immediately and overpowers
liquidity effect.
Interest rate starts .. immediately when the money growth
rate increases.
As time goes, price and income effect results in even ..
interest rate.
31

Homework
Question 1,4,10, 11, 18, 19, 23, 25
(Chapter 5)
Read Chapter 6

11