Chapter 5

The Behaviour of Interest Rates

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Determinants of Asset Demand

1. Wealth - the total resources owned by the individual, including all assets 2. Expected Return - the return expected over the next period on one asset relative to alternative assets

3. Risk - the degree of uncertainty associated with the return on one asset relative to alternative assets
4. Liquidity - the ease and speed with which an asset can be turned into cash relative to alternative assets

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Theory of Asset Demand

1. The quantity demanded of an asset is positively related to wealth.
2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
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Supply and Demand for Bonds I

Bond Demand: At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higheran inverse relationship. Bond Supply: At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lowera positive relationship.

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Supply and Demand for Bonds II

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Derivation of Bond Demand Curve

i = RETe = (F-P)/P
P=$950 i=($1000 - $950)/$950 = 0.053 = 5.3% Bd = $100 billion

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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 determines the equilibrium (or market clearing) price and interest rate

When Bd > Bs excess demand price will rise and interest rate will fall
When Bd < Bs excess supply price will fall and interest rate will rise
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Shifts in the Demand for Bonds I

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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Shifts in the Demand for Bonds II

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Shifts in the Supply of Bonds I

Expected profitability of investment opportunities - in an expansion, the supply curve shifts to the right Expected inflation - an increase in expected inflation shifts the supply curve for bonds to the right Government activities - increased budget deficits/surpluses shift the supply curve to the right/left
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Factors that Shift the Supply Curve of Bonds

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Shifts in the Bond Supply Curve

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Interest Rate Changes from Expected Inflation I

The Fisher Effect:

Increases in expected inflation Bs shifts to right Increases in expected inflation Bd shifts right At the new equilibrium, bond prices have fallen and the interest rate has increased.

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Interest Rate Changes from Expected Inflation II

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Response to a Business Cycle Expansion I

During a business cycle expansion: Income and Wealth are increasing leading to an increase in bond demand. The supply of bonds also increases as firms are more willing to borrow. This leads to an increase in the equilibrium interest rate

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Response to a Business Cycle Expansion II

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Business Cycles and Interest Rates

Business cycle expansions lead to increased interest rates

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Response to a Lower Savings Rate

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Liquidity Preference Framework I

Equilibrium interest rates are determined by the supply and demand for money Two ways to hold wealth: money and bonds Total wealth equals total amount of money and bonds. Bs + Ms = Bd +Md

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Liquidity Preference Framework II

Rearrange terms: Bs - Bd = Md Ms If the bond market is in equilibrium then the money market must also be in equilibrium

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Liquidity Preference Framework III

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Shifts in the Demand for Money

Income Effect - a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right

Price-Level Effect - a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right
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Shifts in the Supply of Money I

Assume that the supply of money is controlled by the central bank. An increase in the money supply engineered by the Bank of Canada will shift the supply curve for money to the right.

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Shifts in the Demand and Supply of Money II

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Changes in the Demand for Money

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Changes in the Supply of Money

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Money Supply and Interest Rates I

Income effect of an increase in the money supply is a rise in the interest rate in response to a higher level of income. Price-Level effect of an increase in the money supply is a rise in interest rates in response to the rise in the price level. The expected-inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate.

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Money Supply and Interest Rates II

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Money Growth and Interest Rates

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