3.

Supply and Demand in the Bond Market

ECO 210 Money and Banking Prof. Sagiri Kitao

Main concepts
y What determines the interest rates? 1.

Supply and demand approach

 The demand and supply curves for bonds.  Market equilibrium where the supply meets the demand.  Interest rates are negatively correlated with bond prices. Hence what

determines the bond prices determines the interest rates.

2.

Liquidity preference framework

Demand for Assets

y What are some of the factors that might influence the

demand for assets in general (bond, stock, real estate, etc)?

Determinants of asset demand

Relationship to asset demand: Positive or negative?
y Wealth y Expected returns

[ [ [ [

] ] ] ]

(relative to alternative assets) y Risk of asset returns

y Liquidity

Risk and asset demand

y Asset A: pays a fixed return of 10%. (less risky) y Asset B: pays a return of 5% half the time and 15% the other

half of the time. (more risky)

 Both assets offer the same expected return but they present

different degrees of risks.  A risk-averse person (most people) prefers to hold less risky asset and a risk-loving person prefers to hold more risky asset.

Risk and asset demand

y Asset A: pays a fixed return of 10%. (less risky) y Asset B: pays a return of 5% half the time and 15% the other

half of the time. (more risky)

 Both assets offer the same expected return but they present

different degrees of risks.  A risk-averse person (most people) prefers to hold less risky asset and a risk-loving person prefers to hold more risky asset.

Liquidity
y Liquidity of an asset:

How quickly an asset can be converted into cash at low costs (easiness to sell)
 Liquid assets: U.S. treasury bills  Less liquid assets: houses

y More liquidity is a plus since it is easier to find a buyer when

its time to sell.

Theory of asset demand: summary

The quantity demanded of an asset is: 1. Positively related to wealth. 2. Positively related to its expected return relative to alternative assets. 3. Negatively related to the risk of its returns relative to alternative assets. 4. Positively related to its liquidity relative to alternative assets.

Equilibrium in the Bond Market: Demand & Supply

Bond demand curve

y Bond demand curve

Graphical representation of the relationship between the quantity of the bond demanded and the price when all other economic variables are held constant (ceteris paribus).

Bond demand curve

The quantity demanded will be lower, when the price

of the bond is higher.

The demand curve is downward-sloping, showing the

negative relationship between the price of bonds and quantity of bonds demanded.
 When the price is higher (i.e. the interest rate is lower), it is

less attractive to buy bonds and the demand falls.

Bond demand curve

Price of bonds, P ($)

900

800

200

300

Quantity of bonds, B ($ billions)

Bond supply curve

y Bond supply curve

Graphical representation of the relationship between the quantity of the bond supplied and the price when all other economic variables are held constant (ceteris paribus).

Bond supply curve

The quantity supplied will be higher, when the price of

the bond is higher. The supply curve is upward-sloping, showing a positive relationship between the price of bonds and quantity of bonds supplied.
 When the price is high (i.e. the interest rate is low), it is less

costly to borrow and firms are more willing to issue and supply (sell) bonds.

Bond supply curve

Price of bonds, P ($)

900

800

200

300

Quantity of bonds, B ($ billions)

Bond market equilibrium

y

Bond demand

Bond supply

Bond market equilibrium

Price of bonds, P ($)

E 850
Equilibrium price

Supply curve

Demand curve

250
Quantity of bonds, B ($ billions)

Bond price and interest rate

y

Bond price and interest rate

y

Bond market equilibrium

y Off the equilibrium, the market tends to head toward and

settle at the equilibrium. y What if the supply exceeds the demand? [Excess supply]
 There is a supply of bonds left unsold without buyers.

The price will fall.

y What if the demand exceeds the supply? [Excess demand]
 There is a demand for bonds unfilled without sellers.

The price will rise.

Bond market equilibrium

Price of bonds, P ($)
Excess supply at price $900

Supply curve 900 850

Demand curve 200 250 300

Quantity of bonds, B ($ billions)

Bond market equilibrium

Price of bonds, P ($)

Supply curve

850 800

Excess demand at price $800

Demand curve 200 250 300

Quantity of bonds, B ($ billions)

Changes in Equilibrium Interest Rates

Changes in the interest rates

Why do the interest rates change? Distinguish between y Movements along a demand (or supply) curve
 The change in quantity demanded (or supplied) as a result of a

change in the price (or interest rates).

y Shifts in a demand (or supply) curve
 The change in quantity demanded (or supplied) at each given

price in response to a change in some other factor beside the price.

Changes in the interest rate

Shift in the demand curve Movement along the demand curve

Factors that shift the demand curve

Relation to the bond demand Positive Positive Negative Positive Shift in demand when the factor RISES Shift-out to the right Shift-out to the right Shift-in to the left Shift-out to the right

Factor Wealth Expected returns Risk of returns Liquidity

Shifts in the demand curve: examples

Shift in demand when the factor rises Shift-out to the right Shift-in to the left Shift-in to the left Shift-in to the left Shift-out to the right

Example Business cycle expansion (boom) Increase in expected interest rate

Change in the factor Increase in wealth Fall in expected return

Increase in expected inflation Fall in expected return relative to alternative assets Increase in the volatility of bond prices Increase in the volatility of stock prices Rise in the risk of bonds Fall in the risk of bonds relative to alternative assets

Factors that shift the supply curve

Relation to the bond supply Positive Positive Positive Shift in supply when the factor RISES Shift-out to the right Shift-out to the right Shift-out to the right

Factor Expected profitability of investments Expected inflation Government deficit

What happens to the bond market equilibrium when expected inflation rises? Answer The price falls and interest rate rises: The Fisher effect

Expected inflation and interest rates

What happens to the bond demand and supply when expected inflation rises? 1. Bond demand The expected return from bonds relative to alternatives (real assets) falls. The demand curve shifts to the left. 2. Bond supply Implies a fall in the real interest rate and a decline in the cost of borrowing. The supply curve shift to the right.

Expected inflation and interest rates

Expected inflation and interest rates

Expected inflation and interest rates

y The Fisher effect

When expected inflation rises, interest rates will rise.

 The rise in expected inflation is good news for borrowers (lower

borrowing cost) and bad news for lenders (lower expected returns). There are more supply and less demand, which both reduce the price in equilibrium (i.e. higher interest rate).

Expected inflation and interest rates (3-months T-bills)

Money Market Equilibrium: Liquidity Preference Framework

Liquidity preference framework

y Liquidity preference framework developed by

John Maynard Keynes

 A model of money demand and supply  An alternative framework that explains the equilibrium interest

rate

Liquidity preference framework

y

Liquidity preference framework

y

Equivalence of liquidity preference framework and bond market equilibrium

y Equating supply and demand for bonds is equivalent to

equating supply and demand for money in liquidity preference framework.

y Two frameworks are closely linked, but differ in practice

because liquidity preference assumes only two assets, money and bonds, and ignores effects on interest rates from changes in expected returns on real assets.

Liquidity preference analysis

y The money demand curve
 Keynes defined money as currency and checking account

deposits that earn a zero rate of return.  As the interest rate rises, the opportunity cost of holding money increases. Therefore, the demand for money falls. The demand curve is downward sloping.
y The money supply curve
 Assume that central bank controls the money supply and it is a

fixed amount. The money supply curve is a vertical line.

Money market equilibrium

Money supply : A vertical line

Money demand: Downward sloping

Money market equilibrium

y

Money market equilibrium

Excess supply at i = 25%

Excess demand at i = 5%

Shifts in the money demand

y Income effect

A rise in income Money demand increases since the value of money increases as a medium of exchange (more transactions) and a store of value (more wealth to hold) y Price level effect A rise in the price level Money demand increases to maintain the level of money holdings in real terms the demand curve shifts out to the right

Shifts in the money demand

Shifts in the money supply

y An increase in the money supply by the central bank (the

Federal Reserve) shifts the money supply curve to the right.

Shifts in the money supply

Summary of shifts
Change in the variable Income Price level Money supply Change in money Change in the demand or supply interest rate

Money supply and interest rates

y Prediction of the liquidity preference analysis

 An increase in the money supply (everything else being

equal) lowers interest rates: liquidity effect.  But the change in the money supply could generate other effects and affect the interest rate.

Money supply and interest rates

y

Effect of higher money growth

y 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

Money growth and interest rates (1950-2008)