Content

• Introduction
• Determinants of asset demand
• The bond demand, supply and equilibrium
• Shifts in the demand of bonds
• Shifts in the supply of bonds
• Changes in the interest rate due to expected inflation: The
Fisher effect
Lecture 3: • Changes in the interest rate due to a business cycle expansion
• The liquidity preference framework
The Behavior of Interest Rates • Changes in equilibrium interest rates in the liquidity
preference framework
• Money supply and interest rates 2

Interest rates - Local currency government

Readings bond rates – Oct 2021

• Mishkin (2021), The Economics of Money,

Banking, and Financial Markets, 13th
edition, Pearson, Chapter 5.
• Cecchetti and Schoenholtz (2014),
Money, Banking, and Financial Markets,
4th edition, McGraw-Hill, Chapters 4 + 6.

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http://www.tradingeconomics.com/bonds
Introduction Introduction
What is the explanation for the interest rate fluctuations in
the figure? • Interest rates are negatively related to the price of
In this lecture, we will look at the behaviour of interest rates bonds, so if we can explain why bond prices change,
we can also explain why interest rates fluctuate.
• We can make use of supply and demand analysis for
bonds and money to examine how interest rates
change.
• Because interest rates on different securities tend to
move together, in this lecture we will act as if there
is only one type of security and one interest rate in
the entire economy.
• In the following lecture, we expand our analysis to
look at why interest rates on different types of
securities differ.
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Determinants of Asset Demand

• Wealth: the total resources owned by the

individual, including all assets
• Expected Return: the return expected over the
next period on one asset relative to alternative
assets
• Risk: the degree of uncertainty associated with the
return on one asset relative to alternative assets
• Liquidity: the ease and speed with which an asset
can be turned into cash relative to alternative
assets
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 Summary Table 1 Response of the Quantity of an Asset
Theory of Portfolio Choice Demanded to Changes in Wealth, Expected Returns, Risk,
and Liquidity

Holding all other factors constant:

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 in the Bond Market Demand for Bonds

• In boom times wealth (and income) rise.
• At lower prices (higher interest rates), Demand for bonds will rise, too. During
recessions demand for bonds will fall.
ceteris paribus, the quantity demanded
• If interest rates in the future are expected to
of bonds is higher: an inverse
fall, long-term bonds will have capital gains
relationship and increased returns, raising the demand
• At lower prices (higher interest rates), for bonds.
ceteris paribus, the quantity supplied of • If the prices of bonds become more volatile,
bonds is lower: a positive relationship the demand for bonds will fall.
• If bonds became more liquid relative to
other assets, the demand for bonds will
increase.
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 Supply of Bonds Figure 1 Supply and Demand for Bonds
• Increased confidence of producers means higher
expected profits: they tend to borrow more.
– Increase supply of bonds = Increase demand for loanable
funds
• A rise in the expected inflation, given nominal
interest rates, would lower the cost of borrowing
(real interest rate).
– Increase supply of bonds = Increase demand for loanable
funds
• Higher government deficits are financed by
government borrowing.
– Increase supply of bonds = Increase demand for loanable
funds
13 14

Market Equilibrium Changes in Equilibrium Interest Rates

Shifts in the demand for bonds:
• Occurs when the amount that people are • Wealth: in an expansion with growing wealth, the
willing to buy (demand) equals the amount demand curve for bonds shifts to the right
that people are willing to sell (supply) at a • Expected Returns: higher expected interest rates
given price in the future lower the expected return for long-
• Bd = Bs defines the equilibrium (or market term bonds, shifting the demand curve to the left
clearing) price and interest rate. • Expected Inflation: an increase in the expected
rate of inflations lowers the expected return for
• When Bd > Bs , there is excess demand, bonds, causing the demand curve to shift to the
price will rise and interest rate will fall left
• When Bd < Bs , there is excess supply, price • Risk: an increase in the riskiness of bonds causes
will fall and interest rate will rise the demand curve to shift to the left
• Liquidity: increased liquidity of bonds results in
the demand curve shifting right
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 Summary Table 2
Figure 2 Shift in the Demand Curve for Bonds Factors That Shift the Demand Curve for Bonds

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Summary Table 3
Shifts in the Supply of Bonds Factors That Shift the Supply of Bonds

• 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 budget: increased budget
deficits shift the supply curve to the right

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 Figure 4 Response to a Change in
Figure 3 Shift in the Supply Curve for Bonds Expected Inflation

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Figure 6 Response to a Business

Cycle Expansion

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Figure 7 Business Cycle and Interest Rates
(Three-Month Treasury Bills), 1951–2020 Application: Japan
• Japan experienced a prolonged recession for two
decades.
• Demand and supply of bonds both fell, raising the
price of bonds and lowering the interest rate.
• Prolonged recession created deflation, making the
expected return on real assets negative.
• Money (cash) became more desirable. Bonds less
desirable than money but still preferable to real
assets.
• Interest rates in Japan were close to zero.

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Application: Impact of Low Savings

on Interest Rates Liquidity Preference Framework
• We have seen that interest rates can be
• US personal savings rate (Personal determined using the equilibrium in the
income - Consumption) was at all time bond market or its mirror image, loanable
low in 1999-2000. funds market.
– Those who buy bonds are the ones who loan
• Low savings imply shrinking of lender- funds and those who sell bonds are the ones
saver funds. who borrow.
• As loanable funds shrink the demand for • If bonds and money are the two categories
bonds falls. of assets people use to store wealth, then
• The price of bonds falls and interest rate equilibrium in bond market will imply
rises. equilibrium in the market for money.
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Supply and Demand in the Market for Money:
The Liquidity Preference Framework
How To Divide Assets Into Money and Bonds

Keynesian model that determines the equilibrium interest rate • Money • Bonds
in terms of the supply of and demand for money. – Currency – Savings deposits
There are two main categories of assets that people use to store – Demand deposits – Time deposits
their wealth: money and bonds. – Bonds
Total wealth in the economy = Bs  M s = Bd + M d – Stocks
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).

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Equilibrium in Bond Market =

Figure 8 Equilibrium in the Market for Money
Equilibrium in Money Market

• Total supply of wealth has to equal to

total demand for wealth:
• Ms + Bs = Md + Bd
• If the bond market is in equilibrium, Bs =
Bd.
• Therefore, the market for money must be
in equilibrium, Ms = Md.

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 Bond vs. Money Market Liquidity Preference
• Why do people want to hold money?
• Equilibrium in the bond market
– To conduct purchases; for transaction
determines bond prices and interest purposes.
rates, since each bond price is associated
– Keynesian definition of money concentrates
with a unique interest rate. on the medium of exchange function and
• Equilibrium in the market for money also assumes that the return on money is zero.
determines the interest rate. • What makes people to hold more money?
• The approaches are interchangeable, – Income increases.
though the effects of some variable – Price level increases.
changes are easier to observe in one – Interest rate drops.
approach over the other. • Opportunity cost of holding money drops.

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Demand for Money in the Changes in Equilibrium Interest Rates in

Liquidity Preference Framework the Liquidity Preference Framework

• As the interest rate increases: • Shifts in the demand for money:

– The opportunity cost of holding money – Income Effect: a higher level of income
increases… causes the demand for money at each
– The relative expected return of money interest rate to increase and the demand
decreases… curve to shift to the right
• …and therefore the quantity demanded – Price-Level Effect: a rise in the price level
of money decreases. causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
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 Summary Table 4 Factors That Shift the
Shifts in the Supply of Money Demand for and Supply of Money

• Assume that the supply of money is

controlled by the central bank
• An increase in the money supply
engineered by the Federal Reserve will
shift the supply curve for money to the
right

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Figure 9 Response to a Change in Figure 10 Response to a Change in

Income or the Price Level the Money Supply

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Price-Level Effect Does a Higher Rate of Growth of the
and Expected-Inflation Effect Money Supply Lower Interest Rates?

• A one time increase in the money supply will cause • Liquidity preference framework leads to
prices to rise to a permanently higher level by the end the conclusion that an increase in the
of the year. The interest rate will rise via the increased
prices.
money supply will lower interest rates:
the liquidity effect.
• Price-level effect remains even after prices have
stopped rising. • Income effect finds interest rates rising
• A rising price level will raise interest rates because because increasing the money supply is
people will expect inflation to be higher over the an expansionary influence on the
course of the year. When the price level stops rising, economy (the demand curve shifts to
expectations of inflation will return to zero. the right).
• Expected-inflation effect persists only as long as the
price level continues to rise. 41 42

Does a Higher Rate of Growth of the Figure 11 Response over Time to an

Money Supply Lower Interest Rates? (cont’d) Increase in Money Supply Growth

• 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 (the demand curve shifts to the right).
• 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 (the demand curve shifts to the
right).
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Figure 12 Money Growth (M2, Annual Rate) and
Interest Rates (Three-Month Treasury Bills), Other readings
1950–2020
Readings:
• Why a U.S. Subprime Mortgage Crisis Is Felt Around the World:
http://www.nytimes.com/2007/08/31/business/worldbusiness/31de
rivatives.html?pagewanted=all
• Kuttner (2010), Monetary Policy Surprises and Interest Rates:
Evidence from the Fed Funds Futures Market:
http://www.newyorkfed.org/research/staff_reports/sr99.pdf
• Shulman, The Downside of the Fed's Zero Interest Rate Policy:
http://www.usnews.com/opinion/blogs/economic-
intelligence/2012/04/30/the-downside-of-the-feds-zero-interest-
rate-policy
• NY Times, Flights to Safety Can’t Hide the Dangers:
http://www.nytimes.com/2012/05/13/your-money/investors-
flights-to-safety-cant-hide-the-danger.html
• The collapse of Lehman Brothers:
http://www.investopedia.com/articles/economics/09/lehman-
brothers-collapse.asp#axzz225rbHwB6
• Times, Three Lessons of the Lehman Brothers Collapse,
http://www.time.com/time/business/article/0,8599,1923197,00.html
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