CHAPTER 5 THE BEHAVIOR OF INTEREST RATES

THE BEHAVIOR OF INTEREST RATES

Examine how nominal interest rates are determined and the factors influence it.

Interest rates are negatively lated with bond price.

Able to explain reason behind change in bond prices and fluctuation of interest rates.
( page 95)

Determinants of Asset Demand

1. For Wealth
Holding everything else constant, an increase in wealth raises the quantity demanded
of an asset.

2. Expected return
An increase in an assets expected return relative to that of an alternative asset,
holding everything else unchanged, raise the quantity demand of the asset.
3. Risk
Holding everything else constant, if an assets risk raises relative to that the alternative
assets, its quantity demanded will fall.
4. Liquidity
The more liquid an asset is relative to alternative assets, holding everything else
unchanged the more desirable it is, and the greater will be quantity demanded.
(see the summary result on table 1 page 95)

Loanable funds Framework: Supply & Demand in the Bond Market.

Interest rate
(i %)
ds Price C$
Bs
A

0.0

I
5.3
11.1
17.6=i
G

2.5
E
3.3

100
200
300
Quantitiy of Bonds

400

500

Figure 1 : Supply & Demand for Bonds

Demand Curve
1. For easy illustration, we use demand for one year discount bonds that make no
coupon payments but pay the owner the $1000 face value in a year.
2. So all the points on demand curve getting from the formula,
i = RETe = F P
P
3. i = interest rate = YTM
e.g

One year bond sells at 950, what is the YTM?

i = RETe = 1000 950 = 5.3 %

950

e.g

one year bond sells at 900. YTM?

i = RETe = 1000 900 = 1 %

900
e.g

One year bond sells at 850. YTM?

i = RETe = 1000 850 = 17.6%

850
and repeat the calculation when: bond price = 800
bond price = 750
so, what is the YPM respectively?
4. with the calculated I and discounted bond price we are able to plot the demand curve.
5. Notice that the higher the bond price the lower the interest rate and vice versa.
Supply Curve
1. At 4750, 100 unit bonds supplied at I = 33%.
2. At $800, 200 unit bonds supplied at I = 25 %
3. The reason behind that the higher the bonds price the more the bonds supplied by
the issuers is the lower the interest rate, the cost of borrowing become cheaper.
4. So at $950, the bond supplied is 500 units at the lower interest rate 5.3%.

Market Equilibrium
1. Equilibrium occurred under the condition Bd = Bs at a given price & interest rate. That
s at point C.
2. It can be called market clearing price.
3. Under excess supply condition, people want to sell more bonds than others want to
buy. So with market forces, price will continue down until equilibrium point.
4. Under excess demand people want to buy more bonds than others want to sell. So,
with market farces price would drive up until equilibrium point.
Supply & Demand Analysis
1. The disadvantage of figure: supply & demand for bonds is interest rates run in an
unusual direction on the right vertical axis.
2. So as we go up the right axis, interest rates fall.
3. Since we are more concerned with the value of interest rates than with the price of
bonds.
4. Then we can plot the supply and the demand for bonds on a diagram that has only a
left vertical that the values of interest rates running in the usual direction.

Bs Demand for Bond

(supply of loanable funds, Ls)

Interest rate (i %)
(i increases )
F

E
G

D
C

i =17.6
B

I
Supply of bonds, Bs
(Demand for loanable funds, Ld)

0.0

300
Quantity of Bonds, B.
(Loanable Funds)

Figure 2: Loanable Funds and Supply and Demand for Bonds.

supply curve for bonds indicate quantity of loans demanded for each value of interest
rate selling bonds ( or reinterpreted as me demand for loan able funds)

Demand curve for bond equivalent to supplying of loan buying bonds. ( or

reinterpreted as the supply of loan able funds)

Changes Equilibrium interest rates.

1. So far we learn about the movement a long the demand or supply curve. That is either
changes in price of bond or interest rate.
2. We learn shifts in the demand. That is changes in quantity demanded or supplied due
to change in the other factors besides the bonds price and interest rate.

Shifts in the demand for bonds.

The factor cause the demand curve for bond shift is:

wealth

Expected returns on bonds relative to alternative assets.

Risk of bonds relative to alternative assets.

Liquidity of bonds relative to alternative assets.

1. wealth

Business cycle expansion => wealth => Bd => Bd shifts to right.

2. Expected interest rate

Expected interest rate in future => expected return for long term bonds =>
Bd=> Bd shifts to left.
3. Expected inflation rate.
Expected inflation => expected return for bond => Bd => Bd shifts to
left.
4. Risk
Riskiness of bonds => Rd => Rd shifts to left.
5. Liquidity
Liquidity of bond => Bd => Bd shifts to right.
Shifts in the supply of bonds.
The factors cause the supply curves for bonds to shift are.

Expected profitability of investment opportunities.

Expected inflation.

Government activities
( page 105)

1. Expected profitability of investment opportunities.

Business cycle expansion
Investment opportunities

Bs => Bs shifts to the right.

2. expected inflation .
expected inflation
real cost of borrowing
Bs => Bs shift to the right.
3. Government deficit.
Government deficit
Rs => Rs shifts the right.
Changes in Expected Inflation: The Fisher Effect.
What is Fisher Effect?
1. It is when expected inflation rises, interest rate will rise.
2. As we know for scenario
Demand For Bond
Expected inflation =>
Expected return on bond i =>
Bd => Bd shifts to left.
Supply for bond
Expected inflation =>
Real cost of borrowing =>
Rs => Rs shift to the right.

When we put these two scenarios under one graph it leads,

Price of bond, P
(P )

interest rate, i
(i )
Bs1
Bs2

P1

i1

P2

i2
Bd1
d

B2
Quantity of funds, B
Liquidity Preference Framework: Supply & Demand in the market for money.
So far we have learned on the loanable funds framework determines the equilibrium
interest rate using supply & demand for bond.
Now we will learn liquidity preference framework.
1. According to Keynes people use money and bonds to store their wealth.
2. Thus Bs +Ms= Bd + Md
3. Inverse relationship between demand for money & interest rate due to concept of
opportunity cost.

Interest rate, (i%)

Ms
A
B
i*=15%

C
D
E
Md

0
300
Figure 3: Equilibrium in the market for money

Quantity of money (M)

Changes in Equilibrium interest rate.

A. Shift in the demand for money.
( page 118)
I

1. Income effect.
Income => Md => Md curse shifts to the right => i

II

2. Price level effect

Price level =>

Md =>

Md curve shifts to the right i =>

III B. Shifts in the supply of money.

1. Ms => Ms curve shifts to right => I
( page 109)
I

Income

II

Price-level

III

Expected- inflation.

B.

Business Cycle Expansion.

Business cycle expansion can shifts the supply & demand curve.
1.

How?
As what we learn previously.
Business cycle expansion
Wealth =>

Bd

Bd shifts to right
For Bs how ?
Business cycle expansion
Investment opportunities
Bs =>
2.

Bs shifts to right.

When we integrate both shifts in supply & demand under one graph.

We neither that i

Bonds price

Inverse relationship between bonds price & interest rate.

Price of Bonds, P
(P
)

interest rate, i
(i )
Bs1

Bs4
P1
P2

i1
2

i2
Bd2

Bd
Quantity of Bonds, B