the behaviour of interest rates

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Chapter 5
The Behaviour of Interest Rates
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Determinants of Asset Demand
1. Wealth - the total resources owned by the individual,
including all assets
2. Expected Return - the return expected over the next
period on one asset relative to alternative assets
3. Risk - the degree of uncertainty associated with the
return on one asset relative to alternative assets
4. Liquidity - the ease and speed with which an asset can
be turned into cash relative to alternative assets
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Theory of Asset Demand
1. The quantity demanded of an asset is positively
related to wealth.
2. The quantity demanded of an asset is positively
related to its expected return relative to alternative
assets.
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to

alternative assets.
4. The quantity demanded of an asset is positively
related to its liquidity relative to alternative assets.
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Supply and Demand for Bonds I
•
Bond Demand: At lower prices (higher interest
rates), ceteris paribus, the quantity demanded
of bonds is higher—an inverse relationship.
•
Bond Supply: At lower prices (higher interest
rates), ceteris paribus, the quantity supplied of
bonds is lower—a positive relationship.
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Supply and Demand for Bonds II
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Derivation of Bond Demand Curve
i = RET
e
= (F-P)/P
P=$950

i=($1000 - $950)/$950 = 0.053 = 5.3%
B
d
= $100 billion
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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.
•
B
d
= B
s
determines the equilibrium (or market clearing)
price and interest rate
•
When B
d
> B
s
 excess demand  price will rise and
interest rate will fall
•
When B
d

< B
s
 excess supply  price will fall and
interest rate will rise
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Shifts in the Demand for Bonds I
•
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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Shifts in the Demand for Bonds II
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Shifts in the Supply of Bonds I
•
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 activities - increased budget
deficits/surpluses shift the supply curve to the
right/left
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Factors that Shift the Supply Curve of Bonds
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Shifts in the Bond Supply Curve
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Interest Rate Changes from Expected Inflation I
The Fisher Effect:
•
Increases in expected inflation  B
s
shifts to
right
•
Increases in expected inflation  B
d
shifts right
•
At the new equilibrium, bond prices have fallen
and the interest rate has increased.
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Interest Rate Changes from Expected Inflation II
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Response to a Business Cycle Expansion I
During a business cycle expansion:
•
Income and Wealth are increasing leading to
an increase in bond demand.

•
The supply of bonds also increases as firms are
more willing to borrow.
•
This leads to an increase in the equilibrium
interest rate
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Response to a Business Cycle Expansion II
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Business Cycles and Interest Rates
Business cycle expansions lead to increased interest rates
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Response to a Lower Savings Rate
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Liquidity Preference Framework I
•
Equilibrium interest rates are determined by
the supply and demand for money

•
Two ways to hold wealth: money and bonds
•
Total wealth equals total amount of money and
bonds.
B
s
+ M
s
= B
d
+M
d
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Liquidity Preference Framework II
Rearrange terms:
B
s
- B
d
= M
d
– M
s
If the bond market is in equilibrium then the
money market must also be in equilibrium
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Liquidity Preference Framework III
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Shifts in the Demand for Money
•
Income Effect - a higher level of income causes
the demand for money at each interest rate to
increase and the demand curve to shift to the
right
•
Price-Level Effect - a rise in the price level
causes the demand for money at each interest
rate to increase and the demand curve to shift
to the right
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Shifts in the Supply of Money I
•
Assume that the supply of money is controlled
by the central bank.
•
An increase in the money supply engineered by
the Bank of Canada

will shift the supply curve for money to the
right.
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Shifts in the Demand and Supply of Money II
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Changes in the Demand for Money