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Lecture 9: Interest rate and asset demand

Mishkin Ch 5 – part A page 93-110

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How is interest rate determined

determined in the bond market by forces of demand and supply (D&S) equals market equilibrium procedure: draw D&S curves, find

equilibrium, see what happens if D&S curves shift.

P i

other things unchanged, P i

2 ...(1 ) (1 ) (1 )nC C C FPi i i

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Shape of supply and demand ( D&S ) curves

At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher - an inverse relationship slope down

At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower - a positive relationship slope upwards

( ) P i D

( ) SP i

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Draw supply and demand curves

X-axis: quantities Y-axis: prices (of bond) demand curve slope downwards supply curve slope upwards intersection is the equilibrium – market

price of a bond, which implies interest rate for the bond.

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Movements along the curves

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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.

When Bd = Bs the equilibrium (or market clearing) 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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Will the equilibrium change?

Would change if there are demand-side or supply-side ‘shocks’ - D&S curves shift.

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Demand-side (buy-side) factors

Wealth—the total resources owned by the individual, including real assets and financial 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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How do they affect demand?Holding all other factors constant, the quantity demanded of an asset is

positively related to wealth positively related to its expected return

relative to alternative asset negatively related to the risk of its returns

relative to alternative assets positively related to its liquidity relative to

alternative assets

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Shifts of the demand curve 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 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 shift to the left

Liquidity—increased liquidity of bonds results in the demand curve shifting right

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Shift of the demand curve

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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 - increased budget deficits shift the supply curve to the right

Supply-side (sell-side) factors

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Why interest rate change?

Demand side factors change Supply side factors change Demand side and supply side factors

combined Market equilibrium change

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Example: expected inflation

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Example: business expansion

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Recap

Theory of asset demand demand and supply curves in bond marketchanges in some factors that would affect

demand and supplyshifts in demand and supply curves

changes equilibrium bond price (interest rate). 2 examples