05.the Behaviour of Interest Rates

7/30/2019 05.the Behaviour of Interest Rates

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Copyright 2011 Pearson Canada Inc. 5 - 1

Chapter 5

The Behaviour of Interest Rates


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Determinants of Asset Demand

1. Wealth - the total resources owned by the individual,including all assets

2. Expected Return - the return expected over the next

period on one asset relative to alternative assets3. Risk - the degree of uncertainty associated with the

return on one asset relative to alternative assets

4. Liquidity - the ease and speed with which an assetcan be turned into cash relative to alternative assets


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Theory of Asset Demand

1. The quantity demanded of an asset is positivelyrelated to wealth.

2. The quantity demanded of an asset is positively

related to its expected return relative toalternative 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 for Bonds I

Bond Demand: At lower prices (higher interest

rates), ceteris paribus, the quantity demanded

of bonds is higheran inverse relationship.

Bond Supply: At lower prices (higher interest

rates), ceteris paribus, the quantity supplied

of bonds is lowera positive relationship.


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Supply and Demand for Bonds II


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Derivation of Bond Demand Curve

i = RETe = (F-P)/P

P=$950

i=($1000 - $950)/$950 = 0.053 = 5.3%

Bd = $100 billion


7/31Copyright 2011 Pearson Canada Inc. 5 - 7

Market Equilibrium

Occurs when the amount that people are willing tobuy (demand) equals the amountthat people are willing to sell (supply) at a givenprice.

Bd = Bs determines the equilibrium (or marketclearing) price and interest rate

When Bd > Bs excess demand price will rise and

interest rate will fall When Bd < Bs excess supply price will fall and

interest rate will rise


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Shifts in the Demand for Bonds II



Shifts in the Supply of Bonds I

Expected profitability of investmentopportunities - in an expansion, the supplycurve shifts to the right

Expected inflation - an increase in expectedinflation shifts the supply curve for bonds tothe right

Government activities - increased budgetdeficits/surpluses shift the supply curve to theright/left



Factors that Shift the Supply Curve of Bonds



Shifts in the Bond Supply Curve



Interest Rate Changes from Expected Inflation I

The Fisher Effect:

Increases in expected inflation Bs shifts to

right

Increases in expected inflation Bd shifts

right

At the new equilibrium, bond prices have

fallen and the interest rate has increased.



Interest Rate Changes from Expected Inflation II



Response to a Business Cycle Expansion I

During a business cycle expansion:

Income and Wealth are increasing leading to

an increase in bond demand.

The supply of bonds also increases as firms

are more willing to borrow.

This leads to an increase in the equilibrium

interest rate


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Response to a Business Cycle Expansion II


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Business Cycles and Interest Rates

Business cycle expansions lead to increased interest rates


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Response to a Lower Savings Rate


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Liquidity Preference Framework I

Equilibrium interest rates are determined by

the supply and demand for money

Two ways to hold wealth: money and bonds

Total wealth equals total amount of money

and bonds.

Bs + Ms = Bd +Md


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Liquidity Preference Framework II

Rearrange terms:

Bs - Bd = Md Ms

If the bond market is in equilibrium then the

money market must also be in equilibrium


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Liquidity Preference Framework III


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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 shiftto the right


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Shifts in the Supply of Money I

Assume that the supply of money is controlled

by the central bank.

An increase in the money supply engineered

by the Bank of Canada

will shift the supply curve for money to the

right.


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Shifts in the Demand and Supply of Money II


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Changes in the Demand for Money


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Changes in the Supply of Money


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Money Supply and Interest Rates I

Income effect of an increase in the money supply is arise in the interest rate in response to a higher level ofincome.

Price-Level effect of an increase in the money supply isa rise in interest rates in response to the rise in theprice level.

The expected-inflation effect of an increase in the

money supply is a rise in interest rates in response tothe rise in the expected inflation rate.


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Money Supply and Interest Rates II


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Money Growth and Interest Rates

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05.the Behaviour of Interest Rates