Chapter 4

Chapter 4
Why Do
Interest
Rates Change?
Determinants of Asset Demand
• An asset is a piece of property that is a store of

value. 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.Wealth
2.Expected return
3.Risk
4.Liquidity
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Example 1: Expected Return

The Demand Curve
• Let’s start with the demand curve.

• Let’s consider a one-year discount bond with
a face value of $1,000.
• In this case, the return on this bond is
entirely determined by its price.
• No coupon payment here.
• The return is, then, the bond’s yield to
maturity.

Derivation of Demand Curve
• Point A: if the bond was selling for $950.

(cont.)
• Point B: if the bond was selling for $900.

How do we know the demand (Bd) at point A

is 100 and at point B is 200?
•Well, we are just making-up those numbers.

•But we are applying basic economics—more
people will want (demand) the bonds if the
expected return is higher.

To continue …
•Point C: P  $850 i  17.6% Bd  300
•Point D: P  $800 i  25.0% Bd  400
•Point E: P  $750 i  33.0% Bd  500
•Demand Curve is Bd in Figure 4.1 which
connects points A, B, C, D, E.
─ Has usual downward slope

Determinants of Asset Demand (2)
The quantity demanded of an asset differs by factor.

1. Wealth: Holding everything else constant, an increase in
wealth raises the quantity demanded of an asset
2. Expected return: An increase in an asset’s expected return
relative to that of an alternative asset, holding everything
else unchanged, raises the quantity demanded of the asset
3. Risk: Holding everything else constant, if an asset’s risk
rises relative to that of alternative assets, its quantity
demanded will fall
4. Liquidity: The more liquid an asset is relative to alternative
assets, holding everything else unchanged, the more
desirable it is, and the greater will be the quantity demanded

Determinants of Asset Demand (3)
Table 4.1 Summary Response of the Quantity of an

Asset Demanded to Changes in Wealth, Expected Returns,
Risk, and Liquidity

Supply & Demand in the Bond
Market
•Because rates tend to move together, we will

proceed as if there is one interest rate for the entire
economy.

Shifts in the Demand Curve
Figure 4.2 Shift in the Demand Curve for Bonds

Factors That Shift Demand Curve (a)
Table 4.2 Summary Factors That Shift the Demand

Curve for Bonds

Factors That Shift Demand Curve (b)
Table 4.2 Summary Factors That Shift the Demand

Curve for Bonds

How Factors Shift the Demand
Curve
1. Wealth/saving
─ Economy , wealth 
─ Bd , Bd shifts out to right
OR
─ Economy , wealth 
─ Bd , Bd shifts out to right

Curve
2. Expected Returns on bonds

─ i  in future, Re for long-term bonds 
─ Bd shifts out to right
OR
─ e , relative Re 

Curve
…and Expected Returns on other assets

─ ER on other asset (stock) 
─ Re for long-term bonds 
─ Bd shifts out to left
These are closely tied to expected interest
rate and expected inflation from Table 4.2

Curve
3. Risk
─ Risk of bonds , Bd 
OR
─ Risk of other assets , Bd 

Curve
4. Liquidity
─ Liquidity of bonds , Bd 
OR
─ Liquidity of other assets , Bd 

Shifts in the Demand Curve
Figure 4.2 Shift in the Demand Curve for Bonds

Derivation of Supply Curve
• How do we know the supply (Bs) at point F

is 100 and at point G is 200?
• Again, like the demand curve, we are just
making-up those numbers.
• But we are applying basic economics—more
people will offer (supply) the bonds if the
expected return (cost) is lower.

Derivation of Supply Curve
• Point F: P  $750 i  33.0% Bs  100

• Point G: P  $800 i  25.0% Bs  200
• Point C: P  $850 i  17.6% Bs  300
• Point H: P  $900 i  11.1% Bs  400
• Point I: P  $950 i  5.3% Bs  500
• Supply Curve is Bs that connects points F, G,
C, H, I, and has an upward slope

Shifts in the Supply Curve
Figure 4.3 Shift in the Supply Curve for Bonds

Factors That Shift Supply Curve
Table 4.3
Summary
Factors That
Shift the Supply
of Bonds
We now turn to the

supply curve.
We summarize the
effects in this
table:

1. Profitability of Investment Opportunities

─ Business cycle expansion,
─ investment opportunities , Bs ,
─ Bs shifts out to right
2. Expected Inflation
─ e , Bs 
3. Government Activities
─ Deficits , Bs 

Figure 4.3 Shift in the Supply Curve for Bonds

Supply and Demand for Bonds
Figure 4.1
Supply and
Demand for
Bonds

Market Equilibrium
The equilibrium follows what we know from

supply-demand analysis:
•Occurs when Bd  Bs, at P*  850, i*  17.6%
•When P  $950, i  5.3%, Bs > Bd
(excess supply): P  to P*, i  to i*
•When P  $750, i  33.0, Bd > Bs
(excess demand): P  to P*, i  to i*

Case: Fisher Effect
What if there is only a change in expected

inflation?

Changes in e: The Fisher Effect
Figure 4.4 Response to a Change

If e  in Expected Inflation
1. Relative Re ,
Bd shifts
in to left
2. Bs , Bs shifts
out to right
3. P , i 

Profiting from Interest-Rate
Forecasts
• Methods for forecasting

1. Supply and demand for bonds: use Flow of
Funds Accounts and judgment
2. Econometric Models: large in scale, use
interlocking equations that assume past financial
relationships will hold in the future

Profiting from Interest-Rate
Forecasts (cont.)
• Make decisions about assets to hold

1. Forecast i , buy long bonds
2. Forecast i , buy short bonds
• Make decisions about how to borrow
1. Forecast i , borrow short
2. Forecast i , borrow long

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Chapter 4

• An asset is a piece of property that is a store of

Copyright ©2015 Pearson Education, Inc. All rights reserved. 4-2

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• Let’s start with the demand curve.

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• Point A: if the bond was selling for $950.

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• Point B: if the bond was selling for $900.

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How do we know the demand (Bd) at point A

•Well, we are just making-up those numbers.

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The quantity demanded of an asset differs by factor.

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Table 4.1 Summary Response of the Quantity of an

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•Because rates tend to move together, we will

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Figure 4.2 Shift in the Demand Curve for Bonds

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Table 4.2 Summary Factors That Shift the Demand

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Table 4.2 Summary Factors That Shift the Demand

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2. Expected Returns on bonds

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…and Expected Returns on other assets

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Figure 4.2 Shift in the Demand Curve for Bonds

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• How do we know the supply (Bs) at point F

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• Point F: P  $750 i  33.0% Bs  100

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We now turn to the

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1. Profitability of Investment Opportunities

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The equilibrium follows what we know from

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What if there is only a change in expected

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Figure 4.4 Response to a Change

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• Methods for forecasting

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• Make decisions about assets to hold

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