11

The Behavior of Interest Rates

Chapter 5

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Nominal Interest RatesNominal Interest RatesNominal interest rates on 3-mo. Treasury Nominal interest rates on 3-mo. Treasury

Bills were about 1% in the fifties. In the Bills were about 1% in the fifties. In the eighties they were 15%. At the end of eighties they were 15%. At the end of 2000, they were above 6%; in the middle 2000, they were above 6%; in the middle of 2003, they were 1%.of 2003, they were 1%.

What is the explanation for these interest What is the explanation for these interest rate fluctuations?rate fluctuations?

The explanation for “the” nominal interest The explanation for “the” nominal interest rate should apply to all nominal rates since rate should apply to all nominal rates since interest rates usually move together.interest rates usually move together.

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Determinants of Asset DemandDeterminants of Asset DemandThe higher the The higher the wealthwealth of an individual, the of an individual, the

higher will be her demand for assets, both higher will be her demand for assets, both financial and real.financial and real.

The higher the The higher the expected returnexpected return from an from an asset compared to other assets, the higher asset compared to other assets, the higher the demand for that asset.the demand for that asset.

The The riskierriskier an asset is, the less there will an asset is, the less there will be a demand for it.be a demand for it.

The more The more liquidliquid an asset is, the higher the an asset is, the higher the demand will be.demand will be.

55

Bond Price and Interest RateBond Price and Interest Rate Bond prices and interest rates are always Bond prices and interest rates are always

inversely relatedinversely related.. A discount bond that matures a year from now and A discount bond that matures a year from now and

priced at $900 carries an interest rate of (1000-priced at $900 carries an interest rate of (1000-900)/900=11.1%.900)/900=11.1%.

A discount bond that matures a year from now and A discount bond that matures a year from now and priced at $800 carries an interest rate of (1000-priced at $800 carries an interest rate of (1000-800)/800=25%.800)/800=25%.

A console that pays $100 per year and sells for A console that pays $100 per year and sells for $1000 carries an interest rate of 10%.$1000 carries an interest rate of 10%.

The same console when sold at $1250 carries an The same console when sold at $1250 carries an interest rate of 8%.interest rate of 8%.

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Demand for BondsDemand for Bonds In boom times wealth (and income) rise. In boom times wealth (and income) rise.

Demand for bonds will rise, too. During Demand for bonds will rise, too. During recessions demand for bonds will fall.recessions demand for bonds will fall.

If interest rates in the future are expected to If interest rates in the future are expected to fall, long-term bonds will have capital gains fall, long-term bonds will have capital gains and increased returns, raising the demand for and increased returns, raising the demand for bonds.bonds.

If the prices of bonds become more volatile, If the prices of bonds become more volatile, the demand for bonds will fall.the demand for bonds will fall.

If bonds became more liquid relative to other If bonds became more liquid relative to other assets, the demand for bonds will increase.assets, the demand for bonds will increase.

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Measuring Demand for BondsMeasuring Demand for Bonds

Typical demand curve would have Typical demand curve would have priceprice of bonds on the vertical axis and of bonds on the vertical axis and quantityquantity of bonds on the horizontal axis. of bonds on the horizontal axis.

If bonds were the only form for funds to If bonds were the only form for funds to be raised, then those who demand to be raised, then those who demand to purchase bonds are the ones who purchase bonds are the ones who supply funds.supply funds.

Demand for bonds is mirror image of Demand for bonds is mirror image of supply of loanable fundssupply of loanable funds..

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Bond Price and Interest RateBond Price and Interest Rate

P

Quantityof bonds

$900

$800

11.1%

25%

i

25%

11.1%

$800

$900

Loanablefunds

An increase in the demand for bonds is the same as an increasein the supply of loanable funds.

i P

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Demand and SupplyDemand and Supply

As the price of bonds falls, lender-As the price of bonds falls, lender-savers will want to buy more: demand is savers will want to buy more: demand is downward sloping.downward sloping.

As the interest rate rises, lender-savers As the interest rate rises, lender-savers will want to supply more funds into the will want to supply more funds into the market: supply of loanable funds is market: supply of loanable funds is upward sloping.upward sloping.

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Demand and SupplyDemand and SupplyAs the price of bonds falls, borrower-As the price of bonds falls, borrower-

investors will be more reluctant to issue investors will be more reluctant to issue bonds: the supply of bonds will be bonds: the supply of bonds will be upward sloping.upward sloping.

As the interest rate rises, borrower-As the interest rate rises, borrower-investors will be more reluctant to investors will be more reluctant to borrow: demand for loanable funds will borrow: demand for loanable funds will be downward sloping.be downward sloping.

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Shifts in the Demand for BondsShifts in the Demand for Bonds WealthWealth: in an expansion with growing wealth, the demand : in an expansion with growing wealth, the demand

curve for bonds shifts to the right curve for bonds shifts to the right Expected ReturnsExpected Returns: higher expected interest rates in the : higher expected interest rates in the

future lower the expected return for long-term bonds, future lower the expected return for long-term bonds, shifting the demand curve to the leftshifting the demand curve to the left

Expected InflationExpected Inflation: an increase in the expected rate of : an increase in the expected rate of inflations lowers the expected return for bonds, causing the inflations lowers the expected return for bonds, causing the demand curve to shift to the leftdemand curve to shift to the left

RiskRisk: an increase in the riskiness of bonds causes the : an increase in the riskiness of bonds causes the demand curve to shift to the leftdemand curve to shift to the left

LiquidityLiquidity: increased liquidity of bonds results in the demand : increased liquidity of bonds results in the demand curve shifting rightcurve shifting right

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Supply of BondsSupply of Bonds Increased confidence of producers means higher Increased confidence of producers means higher

expected profits: they tend to borrow more.expected profits: they tend to borrow more. Increase supply of bonds = Increase demand for Increase supply of bonds = Increase demand for

loanable fundsloanable funds A rise in the expected inflation, given nominal A rise in the expected inflation, given nominal

interest rates, would lower the cost of borrowing interest rates, would lower the cost of borrowing (real interest rate).(real interest rate). Increase supply of bonds = Increase demand for Increase supply of bonds = Increase demand for

loanable fundsloanable funds Higher government deficits are financed by Higher government deficits are financed by

government borrowing.government borrowing. Increase supply of bonds = Increase demand for Increase supply of bonds = Increase demand for

loanable fundsloanable funds

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Impact on Interest Rates of a Sudden Impact on Interest Rates of a Sudden Increase in the Volatility of Gold PricesIncrease in the Volatility of Gold Prices

P

Q of bonds

i

P

P

Gold becomes ariskier asset. Bondsbecome relativelyattractive. Demand forbonds increases. Priceof bonds rise and interestrate falls.

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Impact on Interest Rates When Real Impact on Interest Rates When Real

Estate Prices Are Expected to RiseEstate Prices Are Expected to Rise

Quantity of bonds

P iP i

The expected returns from realestate increases. Bonds becomeless attractive; demand drops.Price of bonds fall and interestrates rise.

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Impact on Interest Rates When Impact on Interest Rates When Recession OccursRecession Occurs

P i

P i

During recessions, investmentopportunities dry up. Businessesscrap expansion plans. Newbonds are not issued. Supply ofbonds falls. The wealth effectof the recession will reduce thedemand for bonds, too. The netresult is increase in the price ofbonds and decrease in the interest rates.

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Business Cycle and Interest RatesBusiness Cycle and Interest Rates

http://research.stlouisfed.org/fred2/graph/?id=DTB3,

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Impact on Interest Rates When Impact on Interest Rates When Expected Inflation FallsExpected Inflation Falls

Q of bonds

P

P i

When expected inflation falls,the expected return on bondsrises: bondholders expectcapital gains. Demand shiftsto the right. On the other hand,at a given nominal interest rate,the fall in expected inflationraises the real interest rate. Thecost of borrowing increases,lowering the supply of bonds.Price rises, interest rate falls.

P i

1818

Expected Inflation and Interest Rates (Three-Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2008Month Treasury Bills), 1953–2008

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

1919

JapanJapan

Japan experienced a prolonged recession for two Japan experienced a prolonged recession for two decades.decades.

Demand and supply of bonds both fell, raising the Demand and supply of bonds both fell, raising the price of bonds and lowering the interest rate.price of bonds and lowering the interest rate.

Prolonged recession created deflation, making the Prolonged recession created deflation, making the expected return on real assets negative.expected return on real assets negative.

Money (cash) became more desirable. Bonds less Money (cash) became more desirable. Bonds less desirable than money but still preferable to real desirable than money but still preferable to real assets.assets.

Interest rates in Japan were close to zero.Interest rates in Japan were close to zero.

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Response to a Business Cycle ExpansionResponse to a Business Cycle Expansion

If this depiction is true, what should we see happen to interest rates?

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http://www.economist.com/finance/displaystory.cfm?story_id=8641615

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Impact on Interest Rates When U.S. Impact on Interest Rates When U.S. Started To Retire Long-Term Debt in 1999Started To Retire Long-Term Debt in 1999

P

P i

i

The announcement that the Treasury will buy back 30-yrbonds raised the price of thesebonds and reduced the interest rate on these bonds. As a result,the yield curve turned down atthe long-term maturity end.

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Impact of Low Savings on Impact of Low Savings on Interest Rates Interest Rates

US personal savings rate (Personal income US personal savings rate (Personal income - Consumption) was at all time low in 1999-- Consumption) was at all time low in 1999-2000.2000.

Low savings imply shrinking of lender-saver Low savings imply shrinking of lender-saver funds.funds.

As loanable funds shrink the demand for As loanable funds shrink the demand for bonds falls.bonds falls.

The price of bonds falls and interest rate The price of bonds falls and interest rate rises.rises.

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Liquidity Preference FrameworkLiquidity Preference Framework We have seen that interest rates can be We have seen that interest rates can be

determined using the equilibrium in the bond determined using the equilibrium in the bond market or its mirror image, loanable funds market or its mirror image, loanable funds market.market.Those who buy bonds are the ones who loan Those who buy bonds are the ones who loan

funds and those who sell bonds are the ones who funds and those who sell bonds are the ones who borrow.borrow.

If bonds and money are the two categories of If bonds and money are the two categories of assets people use to store wealth, then assets people use to store wealth, then equilibrium in bond market will imply equilibrium in bond market will imply equilibrium in the market for money.equilibrium in the market for money.

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How To Divide Assets Into How To Divide Assets Into Money and BondsMoney and Bonds

MoneyMoneyCurrencyCurrencyDemand depositsDemand deposits

BondsBondsSavings depositsSavings depositsTime depositsTime depositsBondsBondsStocksStocks

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Equilibrium in Bond Market = Equilibrium in Bond Market = Equilibrium in Money MarketEquilibrium in Money Market

Total supply of wealth has to equal to total Total supply of wealth has to equal to total demand for wealth:demand for wealth:

Ms + Bs = Md + BdMs + Bs = Md + Bd If the bond market is in equilibrium, Bs = If the bond market is in equilibrium, Bs =

Bd.Bd.Therefore, the market for money must be Therefore, the market for money must be

in equilibrium, Ms = Md.in equilibrium, Ms = Md.

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Bond vs. Money MarketBond vs. Money Market Equilibrium in the bond market determines Equilibrium in the bond market determines

bond prices and interest rates, since each bond prices and interest rates, since each bond price is associated with a unique bond price is associated with a unique interest rate.interest rate.

Equilibrium in the market for money also Equilibrium in the market for money also determines the interest rate.determines the interest rate.

The approaches are interchangeable, The approaches are interchangeable, though the effects of some variable changes though the effects of some variable changes are easier to observe in one approach over are easier to observe in one approach over the other.the other.

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Liquidity PreferenceLiquidity Preference Why do people want to hold money?Why do people want to hold money?

To conduct purchases; for transaction purposes.To conduct purchases; for transaction purposes.Keynesian definition of money concentrates on Keynesian definition of money concentrates on

the medium of exchange function and assumes the medium of exchange function and assumes that the return on money is zero.that the return on money is zero.

What makes people to hold more money?What makes people to hold more money? Income increases.Income increases.Price level increases.Price level increases. Interest rate drops.Interest rate drops.

Opportunity cost of holding money drops.Opportunity cost of holding money drops.

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Liquidity Preference = MdLiquidity Preference = Md The demand for money is drawn with interest The demand for money is drawn with interest

rate on the vertical axis and quantity of money rate on the vertical axis and quantity of money on the horizontal axis.on the horizontal axis.

The higher the interest rate, the higher is the The higher the interest rate, the higher is the opportunity cost of holding money, and the opportunity cost of holding money, and the lower is the amount of money held.lower is the amount of money held.

The demand for money becomes a downward The demand for money becomes a downward sloping curve, a typical demand curve.sloping curve, a typical demand curve.

Increases in income and/or the price level shift Increases in income and/or the price level shift the curve to the right.the curve to the right.

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Equilibrium in the Market for MoneyEquilibrium in the Market for Money For the time being, we will assume that the supply For the time being, we will assume that the supply

of money is determined by the monetary authority, of money is determined by the monetary authority, the central bank.the central bank.

Equilibrium between supply and demand for Equilibrium between supply and demand for money takes place at a unique interest rate.money takes place at a unique interest rate.

If at a given interest rate, Md > Ms, then people will If at a given interest rate, Md > Ms, then people will sell bonds to convert them to cash. Bond prices sell bonds to convert them to cash. Bond prices will go down. Interest rates will go up, reducing will go down. Interest rates will go up, reducing Md.Md.

If Md<Ms, people will convert money into bonds. If Md<Ms, people will convert money into bonds. The price of bonds will go up, lowering the interest The price of bonds will go up, lowering the interest rate until Md=Ms.rate until Md=Ms.

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Impact of an Increase In Income Impact of an Increase In Income (Business Boom) on Interest Rates(Business Boom) on Interest Rates

i

i

M

P i

P i

Q of bonds

3232

Impact on Interest Rates of an Increase Impact on Interest Rates of an Increase in the Price Levelin the Price Level

Price level increase forces people to hold more moneyto make the same purchases. The adjustment in theliquidity preference framework comes about as peoplesell their bonds and keep cash. In the bond market, thesupply of bonds rises, lowering the price and raisingthe interest rate.

M Q of bonds

Pi

i

3333

Impact on Interest Rates of an Impact on Interest Rates of an Increase in MsIncrease in Ms

In the liquidity preference framework, increase in the moneysupply is shown by a rightward shift of Ms. An excess of Msover Md prompts people to buy bonds and thus raise the priceof bonds, lowering the interest rate.

i

M Q of bonds

P i

3434

Impact on Interest Rates of A Rise in Impact on Interest Rates of A Rise in Expected InflationExpected Inflation

An increase in the expected inflation will lower the expected returnson bonds because interest rates will rise forcing capital losses on bonds.On the other hand, bond issuers will expect to pay lower real interestrates in the future and increase their supply. Prices of bonds will falland interest rates will rise. In the liquidity preference framework, thereluctance of bondholders to hold bonds translates into an increase inthe demand for money and a rise in the interest rate.

iP

M Q of bonds

3535

A Rise in the Money Supply May Not A Rise in the Money Supply May Not Lower Interest Rates in The Long-RunLower Interest Rates in The Long-RunMs up => i down (liquidity effect)Ms up => i down (liquidity effect) i down => I up => Y up (income effect) => i down => I up => Y up (income effect) =>

Md upMd upY up => P up (price level effect) => Md upY up => P up (price level effect) => Md upP up => expected inflation up (expected P up => expected inflation up (expected

inflation effect) => Md upinflation effect) => Md up In the liquidity preference framework, In the liquidity preference framework,

income and price level effects will directly income and price level effects will directly translate into a rightward shift of Md.translate into a rightward shift of Md.

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Possible OutcomesPossible Outcomes If the liquidity effect is larger than the other If the liquidity effect is larger than the other

effects, an increase in Ms will lower interest rates.effects, an increase in Ms will lower interest rates. If the liquidity effect is smaller than other effects If the liquidity effect is smaller than other effects

but expectations adjust slowly, an increase in Ms but expectations adjust slowly, an increase in Ms will lower the interest rates initially but will raise will lower the interest rates initially but will raise them in the long run.them in the long run.

If the liquidity effect is smaller than other effects If the liquidity effect is smaller than other effects and expectations adjust quickly, an increase in and expectations adjust quickly, an increase in Ms will only bring an increase in interest rates.Ms will only bring an increase in interest rates.

3737

3838

Quarterly Money Growth Rates Quarterly Money Growth Rates and Short Term Interest Rateand Short Term Interest Rate

3939

Annual Money Growth Rates Annual Money Growth Rates and Short Term Interest Rateand Short Term Interest Rate

4040

Annual Money Growth Rates Annual Money Growth Rates and Short Term Interest Rateand Short Term Interest Rate