The Behaviour of Interest Rates

Ref: Chapters 4, & 5, Miskin (2009, 9th.ed) Chapters 4, & 6, Hubbard (2008, 6th.ed)
ECO553 Monetary Economics March 2012/SH.WONG

Interest the return on capital; to the lender, it is the return received when they extend credit while to the borrower, it is the cost paid when they obtain credit Interest rate the cost of borrowing or the price paid for the rental of funds, expressed as a percentage per year Rate of return payments to the owner of a security plus the change in the value of the security, expressed as a fraction of its purchase price
ECO553 Monetary Economics March 2012/SH.WONG

Suppose RM100,000 is lent out and at the end of the year RM110,000 must be paid back RM100,000 is the principal while RM10,000 is the interest The interest rate is 10,000/100,000 x 100 = 10% To the borrower it is a cost while to the lender it is a return

ECO553 Monetary Economics March 2012/SH.WONG

Nominal interest rate interest rate that does not take inflation into account Real interest rate interest rate adjusted for expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing

ECO553 Monetary Economics March 2012/SH.WONG

Nominal interest rate = real interest rate + expected inflation rate Real interest rate = nominal interest rate expected inflation rate For example, if the nominal interest rate is 10% per annum and the inflation rate is 3.5%, then the real interest rate is actually 6.5%

ECO553 Monetary Economics March 2012/SH.WONG

Sources: Nominal rates from www.federalreserve.gov/releases/H15. The real rate is constructed using the procedure outlined in Frederic S. Mishkin, The Real Interest Rate: An Empirical Investigation, CarnegieRochester Conference Series on Public Policy 15 (1981): 151200. This procedure involves estimating expected
inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal interest rate.
ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics Jan 2010/SH.WONG

 Categories

of credit market instruments are identified based on the variations in the timing of payments received Simple loan
Discount

Involves the principal (P) and interest ( i ) Total payment = P + iP = P(1 + i )

Repays in a single payment Repays the face value at maturity, but receives less than the face value initially.

bond

ECO553 Monetary Economics March 2012/SH.WONG

 Coupon

Fixed-payment

Borrowers make multiple payments of interest at regular intervals and repay the face value at maturity Specifies the maturity date, face value, issuer, and coupon rate (equals the yearly payment divided by face value) Borrower makes regular periodic payments to the lender. Payments include both interest and principal and no lump-sum payment at maturity.
ECO553 Monetary Economics March 2012/SH.WONG

bond

loan

Time Lines for Credit Market Instrument Repayment

ECO553 Monetary Economics March 2012/SH.WONG

Comparing returns across debt types is difficult since timing of repayment differs Solution is the concept of present value: to find a common measure for funds at different times, present each in todays ringgit A ringgit paid to you one year from now is less valuable than a ringgit paid to you today Why? A ringgit deposited today can earn interest and become RM1 x (1+i) one year from today.
ECO553 Monetary Economics March 2012/SH.WONG

Loan able funds financial capital which firms and households can borrow; where firms borrow to finance their investment projects while households borrow to finance their purchases of durable goods and services Savings amount of present income not spent Investment expenditure on capital goods and fixed assets such as buildings, equipment and machines
ECO553 Monetary Economics March 2012/SH.WONG

Liquidity preference desire to hold money (cash) instead of other assets Transactionary motive amount of money held to enable us to undertake our daily purchases Precautionary motive extra amount of money held in case of unforeseen expenditure Speculative motive demand for money created by uncertainty about the value of other assets
ECO553 Monetary Economics March 2012/SH.WONG

Rate of return the payments to the owner of a security plus the change in the value of the security expressed as a fraction of its purchase price

ECO553 Monetary Economics March 2012/SH.WONG

There are various types of interest rates like Overnight Policy Rate (OPR), Base Lending Rate (BLR), Islamic Financing Rate (IFR), discount rate, deposit rate, etc, all of which tend to move in the same direction The two predominant theories on the determination of interest rates Classical Model Keynesian Model

ECO553 Monetary Economics March 2012/SH.WONG

Loanable funds theory introduced by economists under the classical school of thoughts Generally, interest rates is determined through the interaction of the supply of and demand for loanable funds

ECO553 Monetary Economics March 2012/SH.WONG

Bond Market where Bond is the Good

Loanable Funds Market where Use of Funds is the Good Borrower raises the funds Lender supplies the funds Interest rate

Buyer

Lender buys the bond Borrower sells the bond Bond price

Seller
Price

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm

Interest Rate, i (%)

Dm

Ls

4 P=RM9520 3

i=25%
3

2 P=RM8000 1 1

A
Bd

i=5%
1 2 0

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm

Interest Rate, i (%)

Dm

Bs

4 P=RM9520 3

i=25%
3

2 P=RM8000 1 1

i=5%
1 2

D
Ld
4 Quantity of8Loanable Funds, 10

Quantity of Bonds, B (RM million)

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm

Interest Rate, i (%)

Dm

Excess supply of bonds

Bs

Excess supply of loanable funds

Ls

4 P=RM9520

B E C
1

D A
Bd

i=25% i=10% i=5%

C E B

A D
Ld

P=RM9090
2 P=RM8000 1

Excess demand for bonds

Excess demand for loanable funds 2

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Changes in demand for bond or supply of bond will change the bond price and interest rate Theory of portfolio allocation can explain bond demand curve shifts Changes in willingness and ability to borrow shifts the supply curve

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm 1a. Attractiveness of holding bonds rises

Interest Rate, i (%)

Dm

Bs E1

2a. Ability/willingness to lend falls

Ls

P1

1b. Bond price rises 2b. Bond price falls

i2
3

P0 P2

E0

i0 i1

E2 1b. Interest rate rises

E0 E1 Ld

E2
2a. Attractiveness of holding bonds falls

Bd
0

2 1a. Ability/willingness to lend rises

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Increase in Demand for Bonds

Higher expected returns on bonds Higher relative liquidity of bonds Higher wealth Lower expected inflation Lower expected return on other assets Lower relative information costs of bonds Lower relative riskiness of bonds

Decrease in Demand for Bonds Lower expected returns on bonds Lower relative liquidity of bonds Lower wealth Higher expected inflation Higher expected return on other assets Higher relative information costs of bonds Higher relative riskiness of bonds

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm

Interest Rate, i (%)

2a. Attractiveness of issuing bonds falls

Bs

1a. Dm Ability/willingness to borrow rises

Ls E1

P2 P0 P1
1

E 2b. Bond 2 price rises

i1
E0 E1 Bd
0 3

1b. Interest rate rises 1b. Interest rate falls E2

i0 i2

E0

1a. Attractiveness of issuing bonds rises

2a. Ability/willingness to borrow falls

Ld

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Increase in Supply of Bonds

Higher expected profitability of capital Higher government borrowing Higher tax subsidies for investment Lower business tax Higher expected inflation

Decrease in Supply of Bonds Lower expected profitability of capital Lower government borrowing Lower tax subsidies for investment Higher business tax Lower expected inflation

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

1. Household wealth falls Dm

Bs1 Bs0 E0

Interest Rate, i (%)

Dm

Ls1

Ls0

P1

E 3. Bond 1
price rises 2. Expected 1 profitability falls

1. Household wealth falls

P0

i0 i1

3. Interest rate falls

E0
2. Expected profitability falls

E1

Bd1
0 6

Bd0
0

Ld1
L (RM million) Quantity Demanded, Q

Ld0

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Price of Bonds, P (RM)

Dm

Interest Rate, i (%)

1. Higher expected inflation reduces supply of loanable funds

Bs
2. Higher expected inflation increases supply of bonds

i1
3. Interest rate rises

E1

Ls1

Ls0

P0
3. Bond price 1 falls

E0

Bs1
1. Higher expected inflation reduces demand for bonds

i0

E0
2. Higher expected inflation increases demand for loanable funds
2

Ld1

P1
0 6

E1 Bd1

Bd0
0

Ld0
4 Quantity of8Loanable Funds, 10

Quantity of Bonds, B (RM million)

L (RM million) Quantity Demanded, Q

Bond Market Perspective

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

Closed Economy: an economy that neither borrows nor lends to foreign countries Open Economy: capital is mobile internationally World real interest rate (rw): the interest rate that is determined in the international capital market

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

Small open economy: the quantity of loanable funds supplied is too small to affect the world interest rate and the economy takes rw as given Large open economy: an economy that is large enough to affect the world interest rate

ECO553 Monetary Economics March 2012/SH.WONG

World Real Interest Rate, rw (%)

Dm International lending; domestic desired lending exceeds domestic desired borrowing

Ls

rw1=5% rw*=3% rw2=1%

C E B

A D
Ld

International borrowing; domestic desired borrowing 2 exceeds domestic desired lending

4 8 10 Quantity of Domestic Loanable Funds, L (RM million)Q Quantity Demanded,

Loanable Funds Perspective anded, Q

ECO553 Monetary Economics March 2012/SH.WONG

World Real Interest Rate, rw (%)

World Real Interest Rate, rw (%)

United States
Dm

Rest of the World

4 5

Ls
US lends abroad

Ls

rw = 5 r2 =3 w

5 3

1 1

Ld
0 6

Rest of World 2 borrows abroad

Ld

Quantity of Bonds, B (RM million)

4 Quantity of8Loanable Funds, 10

L (RM million) Quantity Demanded, Q

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

Liquidity preference theory introduced by John Maynard Keynes Based on the demand to hold money in liquid form for the purpose of transaction, precaution and speculative

ECO553 Monetary Economics March 2012/SH.WONG

The equilibrium interest rate is determined through the supply of and demand for money Two main categories of assets to store wealth: money and bonds Total wealth in the economy: B s + M s = B d + Md Bs - Bd = Ms - Md When the money market is in equilibrium (Ms = Md) then the bond market is also in equilibrium (Bs = Bd)
ECO553 Monetary Economics March 2012/SH.WONG

The Money Market Equilibrium

Supply of Money, Ms
Surplus

12% Interest Rate

8%

Shortage

4% Demand for Money,Md 500 1,000 2,000 Quantity of Money ECO553 Monetary Economics (RM million) March 2012/SH.WONG 1,500

ECO553 Monetary Economics March 2012/SH.WONG

Income Effecta 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 Effecta 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

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

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

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

ECO553 Monetary Economics March 2012/SH.WONG

Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest ratesthe liquidity effect Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy Price-Level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level Expected-Inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future
ECO553 Monetary Economics March 2012/SH.WONG

A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices Price-level effect remains even after prices have stopped rising A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero. Expected-inflation effect persists only as long as the price level continues to rise
ECO553 Monetary Economics March 2012/SH.WONG