Why Do Interest Rates Change?
Why Do Interest Rates Change?
Why Do Interest Rates Change?
Why Do Interest
Rates Change?
Chapter Preview
In the early 1950s, short-term Treasury bills
were yielding about 1%. By 1981, the
yields rose to 15% and higher. But then
dropped back to 1% by 2003.
What causes these changes?
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Chapter Preview
In this chapter, we examine the forces that
move interest rates and the theories behind
those movements. Topics include:
Determining Asset Demand
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
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.67
R1 = return in state 1
= 12% = 0.12
= 1/3
R2 = return in state 2
= 8%
= 0.08
.33
Thus
Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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2
1
(0.12 0.1068) 2 (0.33 0.168) 2 .094
3
3
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iR
F P
P
$1000 $950
$950
.053 5.3%
B 100
$1000 $900
$900
.111 11.1%
Bd 200
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Market Equilibrium
The equilibrium follows what we know from
supply-demand analysis:
1. Occurs when Bd = Bs, at P* = 850, i* = 17.6%
2. When P = $950, i = 5.3%, Bs > Bd
(excess supply): P to P*, i to i*
3. When P = $750, i = 33.0, Bd > Bs
(excess demand): P to P*, i to i*
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Market Conditions
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
Excess supply occurs when the amount that people are
willing to sell (supply) is greater than the amount people are
willing to buy (demand) at a given price
Excess demand occurs when the amount that people are
willing to buy (demand) is greater than the amount that
people are willing to sell (supply) at a given price
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Factors
That Shift
Demand Curve
Economy , wealth
Bd , Bd shifts out to right
OR
Economy , wealth
Bd , Bd shifts out to left
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OR
e , relative Re
Bd shifts out to right
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Summary of Shifts
in the Demand for Bonds
1. Wealth: in a business cycle expansion with
growing wealth, the demand for bonds rises,
conversely, in a recession, when income and
wealth are falling, the demand for bonds falls
2. Expected returns: higher expected interest
rates in the future decrease the demand for
long-term bonds, conversely, lower expected
interest rates in the future increase the demand
for long-term bonds
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Summary of Shifts
in the Demand for Bonds (2)
3. Risk: an increase in the riskiness of bonds
causes the demand for bonds to fall, conversely,
an increase in the riskiness of alternative assets
(like stocks) causes the demand for bonds
to rise
4. Liquidity: increased liquidity of the bond market
results in an increased demand for bonds,
conversely, increased liquidity of alternative asset
markets (like the stock market) lowers the
demand for bonds
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Summary of Shifts
in the Supply of Bonds
1.
2.
3.
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2.
3.
4.
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Wealth , Bd , Bd
shifts out to right
2.
Investment , Bs
, Bs shifts right
3.
If Bs shifts
more than Bd
then P , i
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