Understanding Interest Rates: Demand, Supply, and Economic Influences

1. Chapter 5 The Behavior of Interest Rates The statement was approved on a 10-2 vote. James Bullard, the president of the Federal Reserve Bank of St. Louis, objected for the first time this year, saying he wanted a stronger commitment from the Fed to keep inflation from falling too low. http://www.bloomberg.com/news/2010-10-05/treasuries-rise-for-second-day-as-bernanke-says-purchases-support-economy.html http://www.cnbc.com/id/101045968 http://www.bloomberg.com/news/2013-09-18/dollar-trades-near-7-month-low-versus-euro-as-fed-avoids-taper.html http://hosted.ap.org/dynamic/stories/O/OIL_PRICES?SITE=AP&SECTION=HOME&TEMPLATE=DEFAULT&CTIME=2013-09-19-06-02-15 http://www.usatoday.com/story/money/markets/2013/09/18/wall-street-in-rally-mode-on-fed-taper-news/2833531/ http://www.proactiveinvestors.com/companies/news/48051/gold-gets-hit-with-fed-pow-wow-in-view-more-hurt-ahead-48051.html http://data.cnbc.com/quotes/.DJI/tab/2 http://video.cnbc.com/gallery/?play=1&video=3000200725 http://www.nasdaq.com/article/markets-spike-on-syria-fedrace-developments-cm276991 http://www.newsking.us/news-5042577-Afternoon:-US-stocks-rose-narrowed-imminent-Fed-statement.html http://www.abc12.com/story/23468488/the-fed-maintains-bond-purchasing-program http://wiki.mises.org/wiki/Money_and_banking_in_Ancient_Rome http://www.lewrockwell.com/2009/07/erik-voorhees/the-record-of-the-federal-reserve/ http://www.youtube.com/watch?v=iYZM58dulPE http://www.youtube.com/watch?v=-3PKHVbOet8 http://www.youtube.com/watch?v=2X5K8NzeFgE http://www.youtube.com/watch?v=_9DH07MBG_w http://www.youtube.com/watch?v=N6RWWWjE2Rc http://www.youtube.com/watch?v=15idnfuyqXs http://www.youtube.com/watch?v=fXqc-yyoVKg http://www.youtube.com/watch?v=iJDQOF_H8kI

2. Bond Demand The quantity of bonds demanded increases as p falls. P D B

3. Bond Demand The quantity of bonds demanded increases as p falls. Bond demand increases in • Expected return relative to other assets • Liquidity relative to other assets • Wealth P D B

4. Bond Demand For 1-year discount bonds held for 1 year, R = i The quantity of bonds demanded increases as p falls. Bond demand increases in • Expected return relative to other assets • Liquidity relative to other assets • Wealth Bond demand decreases in • Riskiness relative to other assets • Expected inflation • Expected interest rate Expected return relative to other assets P D B

5. Bond Supply The quantity of bonds supplied increases as p rises. P S B

6. Bond Supply The quantity of bonds supplied increases as p rises. Bond supply increases in • Expected profitability of investment opportunities • Expected inflation • Government budget deficits P S B

7. Supply and Demand Excess supply: the price suppliers are asking for is too high P D 95 S B 15 25

8. Supply and Demand Excess supply: the price suppliers are asking for is too high • For a zero-coupon $100 bond held for one year P i D 100 95 5.3 95 S B 15 25

9. Supply and Demand Equilibrium: the quantities of bonds supplied and demanded equal • For a zero-coupon $100 bond held for one year P i D 95 5.3 92 S B 15 25 20

10. Supply and Demand Equilibrium: the quantities of bonds supplied and demanded equal • For a zero-coupon $100 bond held for one year P i D 95 5.3 100 92 8.7 92 S B 20

11. Supply and Demand Excess demand: the price suppliers are asking for is low • For a zero-coupon $100 bond held for one year P i D 95 5.3 92 8.7 90 S B 15 25

12. Supply and Demand Excess demand: the price suppliers are asking for is low • For a zero-coupon $100 bond held for one year P i D 95 5.3 92 8.7 100 90 11.1 90 S B 15 25

13. Supply and Demand Equilibrium: the quantities of bonds supplied and demanded equal • For a zero-coupon $100 bond held for one year P i D 95 5.3 92 8.7 90 11.1 S B 15 25 20

14. The Fisher Effect Suppose expected inflation rise by 6 percentage-points. D S P i 95 5.3 B 20

15. The Fisher Effect Suppose expected inflation rise by 6 percentage-points. D S P i 95 5.3 D 92 8.7 B 15 20

16. The Fisher Effect Suppose expected inflation rise by 6 percentage-points. D S P i 95 5.3 S D 92 8.7 90 11.1 B 15 20 The nominal rate of interest rises by 5.8 pct. pts.

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

18. The Fisher Effect Source: FRED

19. The Fisher Effect Source: FRED

20. The Business Cycle and Interest Rates Suppose economic growth is accelerating. D S P i 95 5.3 B 18

21. The Business Cycle and Interest Rates Suppose economic growth is accelerating. D S P i S 95 5.3 92 8.7 B 18 23

22. The Business Cycle and Interest Rates Suppose economic growth is accelerating. D D S P i S 95 5.3 93 7.5 92 8.7 B 18 23 23 The quantity and price of bonds both increase

23. The Business Cycle and Interest Rates Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm. The quantity and price of bonds both increase

24. Keynes’ liquidity preference framework • holding money and buying bonds are the only stores of wealth • the quantity of loanable funds people and firms supply = the value of bonds purchased Total Wealth = Bs + Ms = Bd + Md Bond Market Loanable funds Market Bs–Bd=Ms–Md LD P i BD = 0 if bond market in equilibrium = 0 if loanable funds market in equilibrium = 0 if the market for money is in equilibrium 92 8.7 BS LS L B 15

25. Keynes’ liquidity preference framework • holding money and buying bonds are the only stores of wealth • the quantity of loanable funds people and firms supply = the value of bonds purchased Loanable funds Market LD LD i i 8.7 8.7 LS LS L L 15 15

26. Keynes’ liquidity preference framework • holding money and buying bonds are the only stores of wealth • the quantity of loanable funds people and firms supply = the value of bonds purchased • The interest rate in these markets are the same . Loanable funds Market The market for money LD i i MD 8.7 LS L 15 M

27. The Liquidity Effect • Money supply shifts to the right (increases) if • The Fed injects money into the banking system with OMP • Banking lending increases . Loanable funds Market The market for money LD i i MD 8.7 7.5 LS L 15 M

28. The Price-level Effect • A one time increase in MS permanently raises the price level by end of year:i = r + p • bond demand falls because the return falls • bond supply rises because the cost of borrowing falls • money demand increases (the supply of loanable funds falls) (demand for loanable funds rises) Bond Market Loanable funds Market The market for money P i i BS BD 8.7 8.7 95 5.3 5.3 92 LD MD LS L B L 15 15 M

29. The Expected-Inflation Effect • An increase in MS causes inflation expectations to rise, which may diminish over time. • bond demand falls (the supply of loanable funds falls) • bond supply rises (demand for loanable funds rises) • money demand increases Loanable funds Market The market for money i i 8.7 8.7 5.3 5.3 LD MD LS L 15 M

30. The Income Effect • An increase in MS is an expansionary influence on the economy. • demand for loanable funds rises • money demand increases Loanable funds Market The market for money i i 7.1 7.1 5.3 5.3 LD MD LS L 15 M

31. Figure 11 Response to an Increase in MS Growth The Total Effect

32. Figure 11 Response to an Increasein MS Growth The Total Effect

33. Figure 12 Annual M2 Growth and 3-month T-bill (1950–2011) The Total Effect 4 5 6 2 9 5 a 6 7 7 8 4 3 9 8 1 a 2 3 b 1 b Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.