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# The Behavior of Interest Rates - PowerPoint PPT Presentation

The Behavior of Interest Rates. Chapter 5. Nominal Interest Rates. Nominal interest rates on 3-mo. Treasury Bills were about 1% in the fifties. In the eighties they were 15%. At the end of 2000, they were above 6%; in the middle of 2003, they were 1%.

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Presentation Transcript

Chapter 5

• Nominal interest rates on 3-mo. Treasury Bills were about 1% in the fifties. In the eighties they were 15%. At the end of 2000, they were above 6%; in the middle of 2003, they were 1%.

• What is the explanation for these interest rate fluctuations?

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

• The higher the wealth of an individual, the higher will be her demand for assets, both financial and real.

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

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

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

• Bond prices and interest rates are always inversely related.

• A discount bond that matures a year from now and priced at \$900 carries an interest rate of (1000-900)/900=11.1%.

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

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

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

• In boom times wealth (and income) rise. Demand for bonds will rise, too. During recessions demand for bonds will fall.

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

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

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

• Typical demand curve would have price of bonds on the vertical axis and quantity of bonds on the horizontal axis.

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

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

P

i

i

P

\$800

25%

11.1%

\$900

\$900

11.1%

25%

\$800

Quantity

of bonds

Loanable

funds

An increase in the demand for bonds is the same as an increase

in the supply of loanable funds.

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

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

• As the price of bonds falls, borrower-investors will be more reluctant to issue bonds: the supply of bonds will be upward sloping.

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

• 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

• Increased confidence of producers means higher expected profits: they tend to borrow more.

• Increase supply of bonds = Increase demand for loanable funds

• A rise in the expected inflation, given nominal interest rates, would lower the cost of borrowing (real interest rate).

• Increase supply of bonds = Increase demand for loanable funds

• Higher government deficits are financed by government borrowing.

• Increase supply of bonds = Increase demand for loanable funds

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

i

P

Gold becomes a

riskier asset. Bonds

become relatively

attractive. Demand for

bonds increases. Price

of bonds rise and interest

rate falls.

P

P

Q of bonds

Impact on Interest Rates When Real Estate Prices Are Expected to Rise

The expected returns from real

estate increases. Bonds become

less attractive; demand drops.

Price of bonds fall and interest

rates rise.

P

i

P

i

Quantity of bonds

Impact on Interest Rates When Recession Occurs Expected to Rise

During recessions, investment

scrap expansion plans. New

bonds are not issued. Supply of

bonds falls. The wealth effect

of the recession will reduce the

demand for bonds, too. The net

result is increase in the price of

bonds and decrease in the interest

rates.

P

i

P

i

Business Cycle and Interest Expected to RiseRates

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

Impact on Interest Rates When Expected Inflation Falls Expected to Rise

P

When expected inflation falls,

the expected return on bonds

rises: bondholders expect

capital gains. Demand shifts

to the right. On the other hand,

at a given nominal interest rate,

the fall in expected inflation

raises the real interest rate. The

cost of borrowing increases,

lowering the supply of bonds.

Price rises, interest rate falls.

P

i

P

i

Q of bonds

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

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

Japan Bills), 1953–2008

• Japan experienced a prolonged recession for two decades.

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

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

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

• Interest rates in Japan were close to zero.

Response to a Business Cycle Expansion Bills), 1953–2008

If this depiction is true,

what should we see

happen to interest

rates?

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

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

i

The announcement that the

bonds raised the price of these

bonds and reduced the interest

rate on these bonds. As a result,

the yield curve turned down at

the long-term maturity end.

P

P

i

Impact of Low Savings on Interest Rates Long-Term Debt in 1999

• US personal savings rate (Personal income - Consumption) was at all time low in 1999-2000.

• Low savings imply shrinking of lender-saver funds.

• As loanable funds shrink the demand for bonds falls.

• The price of bonds falls and interest rate rises.

Liquidity Preference Framework Long-Term Debt in 1999

• We have seen that interest rates can be determined using the equilibrium in the bond market or its mirror image, loanable funds market.

• Those who buy bonds are the ones who loan funds and those who sell bonds are the ones who borrow.

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

Money Long-Term Debt in 1999

Currency

Demand deposits

Bonds

Savings deposits

Time deposits

Bonds

Stocks

How To Divide Assets Into Money and Bonds

Equilibrium in Bond Market = Equilibrium in Money Market Long-Term Debt in 1999

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

• Ms + Bs = Md + Bd

• If the bond market is in equilibrium, Bs = Bd.

• Therefore, the market for money must be in equilibrium, Ms = Md.

• Bond vs. Money Market Long-Term Debt in 1999

• Equilibrium in the bond market determines bond prices and interest rates, since each bond price is associated with a unique interest rate.

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

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

Liquidity Preference Long-Term Debt in 1999

• Why do people want to hold money?

• To conduct purchases; for transaction purposes.

• Keynesian definition of money concentrates on the medium of exchange function and assumes that the return on money is zero.

• What makes people to hold more money?

• Income increases.

• Price level increases.

• Interest rate drops.

• Opportunity cost of holding money drops.

Liquidity Preference = Md Long-Term Debt in 1999

• The demand for money is drawn with interest rate on the vertical axis and quantity of money on the horizontal axis.

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

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

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

Equilibrium in the Market for Money Long-Term Debt in 1999

• For the time being, we will assume that the supply of money is determined by the monetary authority, the central bank.

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

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

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

i

P

i

i

P

i

Q of bonds

M

P

i

i

M

Q of bonds

Price level increase forces people to hold more money

to make the same purchases. The adjustment in the

liquidity preference framework comes about as people

sell their bonds and keep cash. In the bond market, the

supply of bonds rises, lowering the price and raising

the interest rate.

i

P

i

Q of bonds

M

In the liquidity preference framework, increase in the money

supply is shown by a rightward shift of Ms. An excess of Ms

over Md prompts people to buy bonds and thus raise the price

of bonds, lowering the interest rate.

P

i

Q of bonds

M

An increase in the expected inflation will lower the expected returns

on bonds because interest rates will rise forcing capital losses on bonds.

On the other hand, bond issuers will expect to pay lower real interest

rates in the future and increase their supply. Prices of bonds will fall

and interest rates will rise. In the liquidity preference framework, the

reluctance of bondholders to hold bonds translates into an increase in

the demand for money and a rise in the interest rate.

• Ms up => i down (liquidity effect)

• i down => I up => Y up (income effect) => Md up

• Y up => P up (price level effect) => Md up

• P up => expected inflation up (expected inflation effect) => Md up

• In the liquidity preference framework, income and price level effects will directly translate into a rightward shift of Md.

Possible Outcomes The Long-Run

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

• If the liquidity effect is smaller than other effects but expectations adjust slowly, an increase in Ms will lower the interest rates initially but will raise them in the long run.

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