Chapter 5: The Behavior of Interest Rates

Summary
1. The theory of asset demand tells us that the quantity demanded of an asset is (a)positively related to wealth, (b)positively related to the expected return on the asset relative to alternative assets, (c)negatively related to the riskiness of the asset relative to alternative assets, and (d)positively related to the liquidity of the asset relative to alternative assets.

2. The supply and demand analysis for bonds provides one theory of how interest rates are determined. It predicts that interest rates will change when there is a Chang in demand because of changes in income (or wealth), expected returns, risk, or liquidity or when there is a change in supply because of changes in the attractiveness of investment opportunities, the real cost of borrowing, or the government budget.

3. An alternative theory of how interest rates are determined is provided by the liquidity preference framework, which analyzes the supply of and demand for money. It shows that interest rates will change when there is a change in the demand for money because of changes in income or the price level or when there is a change in the supply of money.

4. There are four possible effects of an increase in the money supply on interest rates: the liquidity effect, the income effect, the price-level effect, and the expected-inflation effect. The liquidity effect indicates that a rise in money supply growth will lead to a decline in interest rates; the other effects work in the opposite direction. The evidence seems to indicate that the income, price-level, and expected-inflation effects dominate the liquidity effect such that an increase in money supply growth lead to higher - rather than lower- interest rates.


-The interest rates are negatively related to the price of bonds, so if we can explain why bond price change, we can also explain why interest rates fluctuate.

I) Determinants of Asset Demand
Buying an asset, must consider:
-Wealth: total resources owned by the individual
-Expected return: on one asset relative to another
-Risk: the degree of uncertainty
-Liquidity: the ease and speed an asset can be turned into cash.

1. Wealth
-When wealth increase, more resources to buy assets.
-Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.

2. Expected Return
-Measures how much we gain from holding an asset
-An incrase in an asset's expected return relative to that of another --> raises the quantity demanded of the asset.

3. Risk
-If an asset's risk rises --> its quantity demanded will fall

4. Liquidity
-An asset is liquid if the market it is traded has many buyers and sellers.
The more liquid an asset is, the more desirable it is, the higher the quantity demanded.

5. Theory of asset demand
-The above factors assemble to the theory of asset demand
-States that, holding all other factors constant:
a. The quantity demanded of an asset is positively related to wealth
b. The quantity demanded of an asset is positively related to its expected return relative to alternative assets.
c. The quantity demanded of an asset is negatively related to the risk of its returns relative to others.
d. The quantity demanded of an asset is positively related to its liquidity relative to others.

II) Supply and Demand In the Bond Market
1. Demand curve - Expected return is equal to interest rate: i=R(e)=(F-P)/P

2. Supply curve
-An important assumption behind the supply and demand curves for bonds is that all other economic variables besides the bond's price and interest rate are held constant.

3. Market Equilibrium
-B(d)=B(s)
-Excess supply: people want to sell more than buy and the price of the bond will decrease
-Excess demand: people want to buy more than sell and price of the bond will increase

4. Supply and Demand Analysis
-An important feature of the analysis is that supply and demand are always in terms of stocks (amounts at a given time) instead of flows.

III) Changes in Equilibrium Interest Rates
-When quantity demanded changes as a result of a change in price --> movement along the demand curve.
-When D changes at a given price in response to a change in some factor besides the bond's price or interest rate --> shift in demand

1. Shifts in the demand for bonds
-Wealth:
*Increase in wealth --> increase in demand --> shift to the right
*Another factor that affects wealth is the propensity to save. If households save more, wealth increases, and demand for bonds rises --> demand to the right.
*As wealth increase, people demand more bonds at the same price.

-Expected returns
*For one year bonds, interest rate and expected return are the same so nothing besides today's interest rate affects the expected return.
*For bonds with maturities greater than one year, expected return may differ from interest rate.
*For example, a rise in interest rate on a long-term bond from 10%-20@ would lead to a sharp decline in price and a very large negative return.
*Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left.
*Changes in expected returns on other assets can affect demand for bonds - expect higher stock prices --> expected return on bonds today relative to stock would fall, lowering the demand for bonds --> demand curve to the left.

-Risk
*Prices more volatile --> risk increases --> bond less attractive --> demand to the left.
*Volatility of prices of other assets --> make bonds more attractive --> demand to the right.

-Liquidity
*Increased liquidity --> demand to the right
*Reduction of brokerage commissions

2. Shifts in the Supply of Bonds
-Expected Profitability of Investment Opportunities
*The more profitable investments that a firm expects it can make, the more willing it will be to borrow to finance these investments.
*In a business cycle expansion --> supply of bonds increases --> supply curve to the right.

-Expected inflation
*The real cost of borrowing is the real interest rate = nominal - inflation.
*When the expected inflation increases, the real cost of borrowing falls --> the quantity of bonds supplied increases at any given bond price.
*An increase in expected inflation causes the supply of bonds to increase and the supply to the right.

-Government Budget
*US Treasury issues bonds to finance deficits = revenues - expenditures.
*When deficits are large --> issue more bonds --> the supply of bonds to the right.
*Vs. govenment surpluses

IV) Changes in the Interest Rate due to Expected Inflation: The Fisher Effect
1. Expected inflation rises --> expected return falls --> demand to the left
2. Expected inflation rises --> the real cost of borrowing has declined --> supply to shift to the right.
3. Depending on the size of the shifts the quantity of bonds could rise or fall.
4. Fisher effect: when expected inflation rises, interest rate will rise.

V) Changes in the Interest Rate due to a Business Cycle Expansion
1. During expansion, national income increases, more profitable opportunities, higher supply of bonds --> supply to the right.
2. Expansion --> wealth increase --> demand to the right
3. Depending on the shifts, the new interest rate can either rise or fall.

VI) Explaining Low Japanese Interest Rates
1. Prolonged recession --> deflation --> negative inflation rate --> expected return on real assets fall --> expected return on bonds rise --> demand for bonds rise --> demand to the right.
2. Negative inflation --> raise real interest rate --> cost of borrowing increases --> supply to the left.
3. Rise in bond price and a fall in interest rates.

VII) Supply ad Demand in the Market for Money: The Liquidity Preference Framework
1. Alternative model by Keynes
2. Determines the Eq interest rate in terms of the supply and demand for money.
3. Closely related to the supply and demand framework of the bond market.
4. Two main assets for store of wealth: money and bonds --> total wealth in economy must equal the total quantity of bonds plus money in the economy --> B(s) + M(s) = B(d) + M(d) or B(s) - B(d) = M(d) - M(s)
5. If the money market is in eq, (Ms = Md) then bond market is also in eq (Bs = Bd).
6. Interest rate can be found by equating supply and demand for bonds or money.
7. Ignores any effects on interest rates that arise from changes in the expected returns on real assets.
8. Bond supply and demand framework is easier to use when analyzing changes in expected inflation
9. Liquidity preference framework easier to use with changes in income, price level, and supply of money.
10. Keynes have expected return equal to interest rate
11. As interest rate rises, expected return on money falls relative to the expected return on bonds --> money demand fall.
12. Money demand and interest rate are negatively correlated because of opportunity cost - the interest sacrificed by not holding a bond.
14. As interest rate on bonds rises, the opportunity cost of holding money rises --> money is less desirable --> money demand fall
15. Interest above eq -->excess money supply --> people holding more money than wanted --> buy bonds with excess money --> price of bonds increase --> interest rate fall until eq.

VIII) Changes in EQ Interest Rates in the Liquidity Preference Framework
1. Shifts in the Demand for Money
-In LPF, two factors cause the demand curve for money to shift: income and price level
-Income effect
*Income affect money demand because: 1. expansion --> wealth increases --> hold more money as a store of value. 2. hold more money to carry out transactions
*Income increases --> demand to the right.

-Price-Level effect
*Price level increases --> money not as valuable --> hold more money to restore money holdings in real terms to former level.
*A rise in price level --> demand to the right.

-Shifts in the supply of Money
*An increase in the money supply by the Fed will shift supply to the right.

IX) Changes in the EQ Interest Rate due to Changes in Income, Price Level, or Money Supply
1. LPF: When income is rising during an expansion, interest rates will rise.
2. Bond market: ambiguous.
3. When price level increase, interest rates will rise.
4. When money supply increases, interest rate will decline.

X). Money and Interest Rates
1. Increase in money supply will lower interest rates: increase money supply to lower interest rates.
-Income effect
*Increase money supply --> raise national income and wealth --> interest rates will rise
*The income effect of an increase in money supply is a rise in interest rates in response to the higher level of income.

-Price-level effect
*The price level effect from an increase in ms is a rise in interest in response to the rise in price level.

-Expected-Inflation effect
*A rise in interest due to rise in expected inflation rate

-Difference between price level and expected inflation effect - the price level effect remains even after prices have stopped rising, whereas the expected-inflation effect disappears.
-Expected-inflation effect will persis only as long as the price level continues to rise

XI) Does a Higher Rate of Growth of Money Supply Lower Interest Rates?
1. Liquidity effect indicate that money growth will cause a decline in interest rate; income, price-level, and expected-inflation effects indicate a rise in interest rates.
2. Liquidity effect is immediate, income and pl effect take time, expected-inflation can be slow or fast depending on whether people adjust their expectations slowly or quickly when ms increase.
3. Empirical evidence: increase ms --> increase in interest