Chapter 5

The Behavior of
Interest Rates
 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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 Theory of Portfolio Choice

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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 Summary Table 1 Response of the
Quantity of an Asset Demanded to Changes
in Wealth, Expected Returns, Risk, and
Liquidity

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 Bond Price and Maturity Period
• Present value formula
Bond Price or PV = __FV____
(1 + i) n
• From the formula, there is an inverse
relationship between:
– Interest rate and PV or bond price;
– Maturity period and PV or bond price
• For every bond price, there is an interest rate
attached to that price.
4-5
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 Supply and Demand in the Bond
Market
• At lower prices (higher interest rates),
ceteris paribus, the quantity demanded of
bonds is higher: an inverse relationship
• At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is lower: a positive relationship

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 Figure 1 Supply and Demand
for Bonds

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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 defines the equilibrium (or market
clearing) price and interest rate.
• When Bd > Bs , there is excess demand,
price will rise and interest rate will fall
• When Bd < Bs , there is excess supply,
price will fall and interest rate will rise

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 Summary Table 2 Factors That Shift
the Demand Curve for Bonds

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 Changes in Equilibrium Interest
Rates
• Shifts in the demand for bonds:
• 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 returns from other assets also shift the demand
curve for bonds.
• 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 sh ift to the left
• Liquidity: increased liquidity of bonds results in the
demand curve shifting
right
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 Figure 2 Shift in the Demand
Curve for Bonds

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 Summary Table 3 Factors That
Shift the Supply of Bonds

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 Shifts in 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 deficit: increased
budget deficits shift the supply curve to the
right

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 Figure 3 Shift in the Supply
Curve for Bonds

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 Figure 4 Response to a Change
in Expected Inflation

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 Figure 5 Expected Inflation and
Interest Rates (Three-Month
Treasury Bills), 1953–2011

Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An
Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures
involve estimating expected inflation as a function of past interest rates, inflation, and time trends.

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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),
1951–2011

Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.

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 Supply and Demand in the Market
for Money: The Liquidity Preference
Framework

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 Figure 8 Equilibrium in the
Market for Money

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 Demand for Money in the
Liquidity Preference Framework

• As the interest rate increases:

– The opportunity cost of holding money
increases…
– The relative expected return of money
decreases…
• …and therefore the quantity demanded of
money decreases.

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 Summary Table 4 Factors That Shift
the Demand for and Supply of Money

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 Figure 9 Response to a Change
in Income or the Price Level

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 Changes in Equilibrium Interest Rates
in the Liquidity Preference
Framework

• 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

• 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. This causes
interest rate to fall.

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 Figure 10 Response to a
Change in the Money Supply

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 Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?

• Liquidity preference framework leads to the

conclusion that an increase in the money
supply will lower interest rates: the liquidity
effect.
• The liquidity effect has often been used by
politicians to support their argument that
increasing money supply is needed to lower
interest rate.

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 Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
(cont’d)

• Is it correct to conclude that money supply

and interest rate should be negatively
correlated?
• Milton Friedman claims that although an
increase in money supply, holding
everything else constant, will decrease
interest rate, the increase in the money
supply may have other effects on the
economy that may make interest rate rise.

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 Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?

Other Effects of an Increase in Money Supply

• Income Effect – An increase in money
supply increases income and wealth in the
economy, which increases the demand for
money and raises interest rate.
– MV = PY

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 Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
(cont’d)
• Price-Level effect predicts an increase in the
money supply leads to an increase in the
price level, increase in money demand and
to a rise in interest rates. (the demand curve
shifts to the right).
• Expected-Inflation effect provides that an
increase in money supply increases the price
level which may lead people to expect that
prices may continue to rise in the future.
The increase in expected inflation increases
interest rate. (Fisher effect)
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 Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
(cont’d)
• The liquidity effect causes interest rate to fall when money supply
increases. However, the income, price level and expected inflation
effect cause interest rate to rise when money supply increases.
• The combined impact of the four (4) effects of an increase in
money supply on interest rate would depend on which effect is
dominant and how quickly the effect would influence interest rate.
• In general, the liquidity effect takes effect immediately, while the
income and price level effects take some time to work. The
expected inflation effect can be slow or fast, depending on how
quickly people adjust their expectations of inflation when money
growth rate increases.

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Figure 11
Response over
Time to an
Increase in Money
Supply Growth

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 Combined Effects of an Increase
in Money Supply on Interest
Rate
1.In the first scenario, the liquidity effect is larger than the other
effects. So an increase in M, reduces interest rate immediately.
Overtime, the other effects increase interest rate but since the
liquidity effect is dominant, the final interest rate is still lower than
the initial interest rate.
2.In scenario 2, the liquidity effect is smaller than the other effects
and people are slow to adjust their expectations of inflation to a
change in M. Thus, an increase in M causes interest rate to fall
initially because of the liquidity effect. Overtime, the other effects
become dominant, raising interest rate to a final level which is
higher than the initial interest rate.
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 Combined Effects of an Increase
in Money Supply on Interest
Rate
3. In scenario 3, people are quick to adjust their expectation of
inflation to the increase in money supply and the liquidity effect is
smaller than the other effects. Hence, an increase in M increases
interest rate immediately because of the expected inflation effect.
Then overtime the income and price level effects reinforce the effect
of expected inflation on interest rate cause interest rate to further
increase to a higher final level.
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 Figure 12 Money Growth (M2, Annual
Rate) and Interest Rates (Three-
Month Treasury Bills), 1950–2011

Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

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 • Reference:

Mishkin, Frederic S. (2014), Economics of Money,

Banking, and Financial Markets (10th ed), Pearson
Education South Asia Pte. Ltd.

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