1、chapter 4 The behavior of Interest rates,Chapter Preview,In this chapter, we examine the forces the move interest rates and the theories behind those movements. Interest rate in negatively related to bond price Topics include: Determining Asset Demand Supply and Demand in the Bond Market Changes in
2、Equilibrium Interest Rates,Determinants of Asset Demand,Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:1. Wealth2. Expected return3. Risk4. Liquidity,Wealth Holding everything else constant, a
3、n increase in wealth raises the quantity demanded of an asset.,Expected ReturnsAn increase in an assets expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset.,RET e=p1RET1+p1RET2+pnRETn,Risk will affect the demand of th
4、e asset Standard deviation, a measure of risk Equation :,risk,There has two bonds X and Y, the bond X and Y have the following probability distributions of expected future returns:,Calculate the expected rate of return for bond Y. Calculate the standard deviation of expected return of bond X and bon
5、d Y. Of these two bonds, which is riskier? (expected rate of return for bond X is 12%),Question:,Solution:,a. RET e=p1RET1+p1RET2+pnRETn,=0.1(35%)+0.20+0.420%+0.225%+0.145% =14%,b.,=,=12.2%,=,=20.35%,12.2%20.35% so, bond Y is a riskier bond,Liquidity The more liquid an asset is relative to alternati
6、ve assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded.,All the determining factors we have just discussed can be assembled into the theory of asset demand, which states as follows:,Our first approach to the analysis of interest-rate det
7、ermination looks at supply and demand in the bond market. The first step in the analysis is to obtain a bond demand curve.,Demand curve,Interest rate in negatively related to bond price Which is plotted as point A in the following figure,Supply curve,The supply curve shows the relationship between t
8、he quantity supplied and the price when all other economic variables are held constant.,Supply and demand for bands,At lower prices of the bond (everything else being equal), the quantity demanded is higher. As the price increase (everything else being equal), the quantity supply increases.,Market e
9、quilibrium,In economics, 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. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied:,Mark
10、et clearing interest rate,market-clearing price,Market clearing interest rate,market-clearing price,Excess demand,Excess supply,Excess demand,Excess supply,Because economists are typically more concerned with the value of interest rates than with the price of bonds, we could plot the supply of and d
11、emand for bonds on a diagram that has only a left vertical axis that provides the values of interest rates running in the usual direction , rising as we go up the axis.,Supply and Demand Analysis,Loanable funds framework,Question：,An important way in which the federal reserve decreases the money sup
12、ply is by selling bonds to the public. Using the loanable funds framework, show what effect this action has on interest rates.,When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve Bs and Bd occurs at a higher equilibrium interest rate, and the inte
13、rest rate rises.,Solution:,Shift in the demand for bonds,Wealth Expected of bonds relative to alternative assets Risk of bonds relative to alternative assets Liquidity of bonds relative to alternative assets,Changes in equilibrium interest rates,Shift in the demand curve for bonds,How Factors Shift
14、the Demand Curve,1.Wealth: economy ,wealth ,Bd, Bd shift to out righteconomy,wealth , Bd, Bd shift to out left 2. Expected Return:iin future, demand for long-term bonds , Bd shifts out to lefti in future, demand for long-term bonds , Bd shifts out to right e , Bd, Bd shifts out to left ,3.RiskRisk o
15、f bonds , Bd , Bd shifts out to leftRisk of other assets , Bd , Bd shifts out to right 4.LiquidityLiquidity of bonds , Bd , Bd shifts out to rightLiquidity of other assets , Bd ,Bd shifts out to left,Factors That Shift Demand Curve,Shift in the supply of bonds,Expected profitability of investment op
16、portunities Expected inflation Government activities,Shift in the supply curve for bonds,How Factors Shift the Supply Curve,1.Profitability of Investment Opportunities:economy, investment opportunities , Bs , Bs shifts out to righteconomy,investment opportunities, Bs, Bs shifts out to left 2.Expecte
17、d inflation:e , Bs , Bs shifts out to right 3.Government activities:Deficits , Bs , Bs shifts out to right,Factors That Shift Supply Curve,Changes in Expected Inflation: The Fisher Effect,When expected inflation rises,interest rates will rise.,If e 1.Relative Re , Bd shifts in to left2.Bs , Bs shift
18、s out to right3.P , i ,Why many economists recommend that the fight against inflation must bo won if we want to lower interest rates.,The interest rate on three-month T-bills has usually moved along with the expected inflation rate.,Question：,The president of the United States announces in a press c
19、onference that he will fight the higher inflation rate with a new antiinflation program. Predict what will happen to interest rates if the public believes him.,If the public believes the presidents program will be successful, interest rates will fall. The presidents announcement will lower expected
20、inflation so that the expected return on goods decreases relative to bonds. The demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The res
21、ulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd, causes the equilibrium bond price to rise and the interest rate to fall.,Solution:,Business Cycle Expansion,The effects of a business cycle expansion on interest rates.,1.Wealth , Bd , Bd shifts out to ri
22、ght 2.Investment , Bs , Bs shifts right 3.If Bs shifts more than Bd then P , i ,This plots the movement of the interest rate on three-month u.s ,T-bills from 1951 to 1998 and indicates when the business cycle is undergoing recessions (shaded areas).,As we can see,the interest rate rises during busin
23、ess cycle expansions and falls during recessions,which is what the supply and demand diagram indicates.,The Liquidity Preference Framework ：Supply and Demand in the Market for Money,Whereas the loanable funds framework determines the equilibrium interest rate using the supply of and demand for bonds
24、, an alternative model developed by John Maynard Keynes, known as the liquidity preference framework, determines the equilibrium interest rate in terms of the supply of and demand for money.,The starting point of Keyness analysis is his assumption that there are two main categories of assets that pe
25、ople use to store their wealth: money and bonds.,The rewritten equation tells us that if the market for money is in equilibrium（Ms=Md）, the right-hand side of Equation equals zero, implying that Bs=Bd , meaning that the bond market is also in equilibrium. In this sense, the liquidity preference fram
26、ework, which analyzes the market for money, is equivalent to the loanable funds framework, which analyzes the bond market.,The demand for money and the interest rate should be negatively related by using the concept of opportunity cost.,Changes in Equilibrium Interest Rates in the Liquidity Preferen
27、ce Framework,Shifts in the In Keyness liquidity preference analysis, two factors cause the demand curve for money to shift: Income and the price level,Shifts in the Demand for Money,Shifts in the Demand for Money,Income Effect In Keyness view, there were two reasons why income would affect the deman
28、d for money. First, as an economy expands and income rises, wealth increases people will want to hold more money as a store of value. Second, as the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more mo
29、ney. The conclusion is that a higher level of income causes the demand for money to increase and the demand curve to shift to the right.,Changes in Income,Shifts in the Demand for Money,Price-Level Effect,Question:Why should a rise in the price level (but not in expected inflation) cause interest ra
30、tes to rise when the nominal money supply is fixed .,Changes in the Price Level,Shifts in the Demand for Money,Price-Level Effect When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their ho
31、ldings of money in real terms to its former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money to increase and the demand curve to shift to the right.,Factors That Shift the Demand for and Supply of Money,Question：,An importa
32、nt way in which the federal reserve decreases the money supply is by selling bonds to the public. Using the liquidity preference framework, show what effect this action has on interest rates.,With the liquidity preference framework, the decrease in the money supply shifts the money supply curve Ms t
33、o the left, and the equilibrium interest rate rises.,Solution:,Shift in the supply of money,We will assume that the supply of money is completely controlled by the central bank, Supply of Money which in the United States is the Federal Reserve. For now, all we need to know is that an increase in the
34、 money supply engineered by the Federal Reserve will shift the supply curve for money to the right.,Changes in the Money Supply,Change in the Money Supply,Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?,Of all the effects, only the liquidity effect indicates that a higher rate
35、 of money growth will cause a decline in interest rates. In contrast, the income, price-level, and expected-inflation effects indicate that interest rates will rise when money growth is higher.,Generally, the liquidity effect from the greater money growth takes effect immediately, because the rising
36、 money supply leads to an immediate decline in the equilibrium interest rate.,The income and price-level effects take time to work, because it takes time for the increasing money supply to raise the price level and income, which in turn raise interest rates. The expected-inflation effect, which also raises interest rates, can be slow or fast, depending on whether people adjust their expectations of inflation slowly or quickly when the money growth rate is increased.,
