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The determination of bond prices and interest rates. Mishkin, Chap 5. Chap 5 discusses: The classical theory of bond prices and interest rates The liquidity preference theory (Keynesian theory) of bond prices and interest rates

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Presentation Transcript
slide2

Chap 5 discusses:

  • The classical theory of bond prices and interest rates
  • The liquidity preference theory (Keynesian theory) of bond prices and interest rates
  • Critique of the liquidity preference theory - Money supply and the market interest rates
slide3

Difference between a market for loans and a bond market – a recap

  • In a market for loans, the interest rate on a loan is determined by market forces of demand and supply.
  • Given a LV and n, the FP is then determined from the PV relationship. Equivalently, given FP and n, the LV is then determined from the PV relationship.
  • In a market for bonds, the bond price is determined by market forces or demand and supply.
  • Given C, FV and n, the interest rate or yield to maturity is then determined from the PV relationship.
  • Thus the difference lies in which is regarded as the market determined variable – price or interest rate.
slide4

The classical theory of bond prices and interest rates

  • Demand for a bond (generally for any asset) depends on:
  • average time preference of households; the more willing the households are to defer their current consumption, the _________ the demand.
  • average wealth level of households ; the higher the wealth level, the _______ the demand
  • expected return on the bond over the holding period; the greater the expected return the ________ the demand
  • the risk on the bond; assuming agents to be risk averse, the greater the risk, the ________ the demand. Risk is often measured by _______
  • the liquidity of the bond; the greater the liquidity the _______ the demand. Liquidity is often measured by ________
slide5

Demand for bonds

Given wealth, savings propensities, risk and liquidity, quantity demanded of bond is _________ related to the expected return on it.

If so, how is the quantity demanded related to the current market price of the bond? Hint: Back to chap 4

for short term investors: one period RET = (C + Pt+1 – Pt)/Pt

for someone who holds till maturity: RET = YTM based on the current market price

How is RET related to Pt in both cases?

Hence quantity demanded is _______ related to current market price. The demand curve for bonds shows

slide6

Supply of bonds

From the issuer’s (borrower’s) point of view, what is the cost of borrowing?

Hence, quantity supplied of bonds is _______ related to its current market price everything else constant. The supply curve of a bond shows

Equilibrium in the bond market:

the price at which quantity demanded ________ quantity supplied.

If bond price > market clearing price

If bond price < market clearing price

Equilibrium price implies a corresponding equilibrium interest rate. Why?

slide7

price of the bond

  • Draw the demand and supply of the bond. Indicate the sources of each (who demands or supplies?)
  • Add a third interest rate axis to alternatively express these relationships.

quantity of the bond

slide8

The market for loanable funds is another name for the market for bonds. Demand for bonds = __________ loanable funds;Supply of bonds = __________ loanable funds;

Interest rate

Draw the supply of and demand for loanable funds and also mark them with their alternative labels.

Quantity of bonds

slide9

Factors affecting demand, supply and the equilibrium interest rate

  • increase in the average wealth level?
  • 2. increase in expected (future) interest rate?

Price of the bond

S0

D0

Quantity of the bond

Price of the bond

Hint: What happens to the future price of the bond? What happens to the one period rate of return?

S0

D0

Quantity of the bond

slide10

3. increase in the expected return on an alternative asset such as a stock or another bond?

4. increase in the riskiness of the bond; effect on an alternative asset

Price of the bond

S0

D0

Quantity of the bond

P

S0

D0

Q

slide11

5. increase in the liquidity of the bond? effect on an alternative asset

6. Increase in the expected (future) inflation rate, assuming this is a nominal bond?

P

S0

D0

Q

P

What happens to the equilibrium nominal interest rate?

S0

D0

Q

slide12

increase in business profitability?

  • 8. increase in the government budget deficit?

P

S0

D0

Q

P

S0

D0

Q

changes in e the fisher effect
Changes in e: the Fisher Effect

Price of a bond

What happens to demand and

supply as πeincreases?

Are the shifts equal?

What happens to equilibrium

price?

Equilibrium quantity?

Equilibrium nominal interest

rate?

S0

D0

Quantity of bond

effects of business cycles expansion
Effects of Business cycles - expansion

Price of a bond

What happens to demand and

supply during expansions?

Are the shifts equal?

What happens to equilibrium

price?

Equilibrium quantity?

Equilibrium interest rate?

S0

D0

Quantity of bond

slide15

II. Liquidity preference or Keynesian theory of the interest rate

  • Assume only 2 types of assets, bonds and money
  • Bs + Ms = Bd + Md = total wealth of individuals
  • or Bs – Bd = Md – Ms
  • If the money market is ___________, the bond market is ____________also. Excess ________ in the bond market implies excess _______ in the money market and the reverse.
  • The bond market can be analyzed by analyzing the money market. (Note: method doesn’t work if there are more than 2 assets)
  • Demand for money: money is demanded
  • because of its
  • this component depends on
  • because it can act as a
  • this component
slide16

Supply of money: assumed constant for the present

Money market equilibrium: assuming _______ price level and income level, the __________ at which Md = Ms

Interest rate

The demand for and supply of money and show the equilibrium interest rate.

Quantity of money

slide17

Factors that affect demand, supply and the equilibrium interest rate, according to the liquidity preference theory:

1. an increase in income?

2. an increase in the price level?

3. An increase in money supply?

Interest rate

i

Quantity of money

M

i

(3) is called the liquidity effect of an increase in money supply.

M

slide18

III. Critique of LP theory

Major difference between the classical and the Keynesian (LP) theory:

The Keynesian theory ignores some other effects of an increase in money supply on the interest rate. These are

-

-

-

Of the above three, the classical theory of interest emphasizes _____ as the most important quantitatively in the long run.