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Chapter 5 The Behavior of Interest Rates

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Chapter 5 The Behavior of Interest Rates. ?. ?. Interest rate are low today because of: QE-4, Fed buying $30 b of MBS and $35 b of Treasury bonds each month. Eurozone debt crisis Corporate sector excess cash Financial institutions’ large surplus funds

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slide2
Interest rate are low today because of:
  • QE-4, Fed buying $30 b of MBS and $35 b of Treasury bonds each month.
  • Eurozone debt crisis
  • Corporate sector excess cash
  • Financial institutions’ large surplus funds

Investors will adjust their portfolios in expectation of when the Fed will tighten monetary policy.

  • Fed is reducing its of bond buying and could exit QE by the end of 2013 if economic growth accelerates. This will increase Treasury yields and reduce bond prices. So investor demand for longer-term bonds will decline, pushing up interest rates.
  • Markets expect Fed to end ZIRP in first quarter of 2015. Fed will raise fed funds rate when the unemployment rate falls below 6.5% and 2-year inflation expectations rise above 2.5%.
  • Banks are decreasing interest rate risk by investing short term.
the big question does a ms i
The Big QuestionDoes a MS  =>  i ?

Effects of MS on i

1. Liquidity Effect

Ms, Ms shifts right, i

2. Income Effect

Ms, Income , Md, Md, i

3. Price Level Effect

Ms, Permanent Price level , Md, Md, i

4. Expected Inflation Effect

Ms => Fe => Bd &Bs (Fisher effect) => i

Answer:

Effect of higher DM/M on i is ambiguous

If assume Ceteris Paribus

slide4

Derivation of Bond Demand Curve

Assume

  • 1-Yr discount bond (no coupon payments)
  • Pays $1,000 face value in one year
  • Holding period = 1 year , then return = i = YTM

i = RetE = (F – P)/P

For each P, there is a corresponding i

If P = $950, then i = (1,000 - $950)/950 = 0.053

Assume QD = $100 billion

If P = $750, then i = (1,000 - $750)/750 = 0.333

Assume QD = $500

Law of Demand

(lower price => higher QD)

(higher return => higher QD)

slide5

Determinants of Asset Demand

QD = f(P/i; Wealth, RE, Risk, Liquidity)

+ + - +

  • Wealth = total resources owned

Y  => W  => DB

MPS  => W  => DB

  • RE = C/P + (PEt+1- Pt)/Pt

iEt+1 => PEt+1 => RE => DB

FE => relative RE => DB

relative to other assets

  • Risk = degree of return uncertainty

relative to other assets

  • Liquidity = ease and speed of turning asset into cash relative to other assets
slide6
Factors That Lower Long-Term Interest Rates by Increasing the Demand for Bonds

Wealth:

Economic Expansion => Increasing wealth => increased demand for bonds => Pbonds increases => rbonds decreases

Expected Interest Rates:

Lower expected interest rates in the future => raise the expected return of long-term bonds => increased demand for bonds => Pbonds increases => rbonds decreases

Stock Market:

Lower expected stock prices in the future => expected return on bonds relative to stocks would rise => increased demand for bonds => Pbonds increases => rbonds decreases

Expected Inflation:

Falling expected rate of inflation => raises the expected return on bonds relative to the expected return on real assets => increased demand for bonds => Pbonds increases => rbonds decreases

Risk:

Increase in riskiness of alternative assets => increased demand for bonds => Pbonds increases => rbonds decreases

Liquidity:

Decreased liquidity of alternative assets => increased demand for bonds => Pbonds increases => rbonds decreases

slide7

Bond Supply Curve

Relationship between QS and P

As P , i  => less costly for firms to borrow =>

 borrowing => QS

QS = f(P/i; PI, FE, Def.)

+/- + + +

  • PI = Profitability of investment opportunities

AD => P => P = PY – Costs =>  I =>  Y

  • FE = Expected inflation (return on real assets)

r = i - FE

  • Def. = Government Deficits
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Econ 330

Homework 3Due Friday, February 14

Chapter 5

Questions & Applied Problems: 14, 18, 19, 20, 23, 24, 25