ECO 551

Monetary Economics
Chapter 4
The Behavior of Interest Rate
Main Textbook:
Mishkin, Frederic S. (2009). The Economics of Money, Banking & Financial Market,
9th Edition, New York : Pearson Addison Wesley
http://www.cwu.edu/~saunders/ec330/ec330ppt.html
http://www.financeformulas.net/Yield_to_Maturity.html

LEARNING OBJECTIVES
Interest rates and rates of returns
Real and nominal interest rates
Theories on the determination of interest
rates

Classical model

(Bond Market and Loanable Funds Market

Analysis)

Keynesian model

(Liquidity Preference Theory)

2

Measuring Interest Rate

Interest is a return on capital.

Also refer to price of money.

1. Yield to maturity (YTM)

YTM is the most accurate measure of interest rate.

YTM is the interest rate that equates the PV payments

received from a debt instrument with its value today.

Also call internal rate of return (IRR).

Coupon Bond
o To know the concept, we can use coupon bond as an example.
o Coupon bond pays the owner of the bond a fixed interest
payment (coupon payment) every year until the maturity date,
when a specified final (face value / par value) is repaid.
o For example:
o A coupon with $1000 face value, might pay you a coupon
payment of $100 per year for 10 years and at maturity date
repay you the face value amount of $1000.
o It issues by corporation or government agency.
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=

. . . +

2
3
n
1+i
(1+i )
(1+i )
(1+i )
(1+i ) n
4

Table 1
YTM on a 10%-Coupon-Rate Bond Maturing in Ten Years (Face Value = $1,000)

When the coupon bond is priced at its face value, the YTM
equals the coupon rate
(P=F, YTM=C)

The price of a coupon bond and the yield to maturity are

negatively related

The YTM is greater than the coupon rate when the bond price
is below its face value
(P<F,YTM>C)

Important fact: Current bond prices and YTM are negatively

related. When the interest rate rises, the price of the bond
falls, and vice versa.

Interest Rate and Rate of Return

1. Interest rates

Interest is a return on capital, also refers to the price of money.

For the borrower, interest is a payment for obtaining credit (loan)

or the cost of borrowing.

For the lender, it is the amount of funds, valued in terms of money

that they receive when they extend credit. It is a reward for delaying
their current consumption.

Interest rate is the ratio of interest to the amount lent.

For example:

Suppose that $100 is lent and, at the end of one year, $110 must
be pay back. The interest paid is $10 and the interest rate is 10%
($10/$100=0.10)

2. Rates of returns (ROR)

Nominal and real interest rates

1. Nominal interest rates

Is the rate of interest that is accrued at some time in the

future.

It is the rate of exchange between RM now and RM in the

future

For example:

if the nominal interest rate is 10% per annum, then a sum

of RM10 borrowed this year, is payable for a sum of RM11
next year.

It ignores the effects of inflation

2. Real interest rates

Is the rate of interest that is adjusted by subtracting expected

changes in the price level (inflation), so that it more accurately
reflects the true cost of borrowing.

The real interest rate is more accurately defined by Fisher equation

(name for Irving Fisher).

The Fisher equation states that the nominal interest rate (i)
equals the real interest rate + the expected rat of inflation.

Real

= Nominal

Expected Inflation

Nominal

= Real

Expected Inflation

If the nominal interest rate is 10% and the inflation rate is 3%, the
real interest rate is really 7%.

From the Fisher equation, a higher expected inflation rate would

reduce the real interest rate.

When the real interest rate is low, there are greater incentives to
borrow and fewer incentives to lend.

Determinants of Asset Demand

(Theory of portfolio choice)
There are 4 factors that we must be considered in holding/
buying an asset.

Wealth: the total resources owned by the individual,

including all assets

Expected Return: the return expected over the next

period on one asset relative to alternative assets

Risk: the degree of uncertainty associated with the

return on one asset relative to alternative assets

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

Holding all other factors constant:
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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Summary Table 1
Response of the Quantity of an Asset Demanded to Changes
in Wealth, Expected Returns, Risk, and Liquidity

Theories on the determination of interest rates

Classical model
Loanable Funds Framework
(Demand and supply in the Bond market)

Demand for bonds

= Lenders

Supply of bonds

= Borrowers

Demand for loanable funds

= Borrowers

Supply of loanable funds (from saving)

= Lenders

Demanders for bonds

= Supplier of loanable funds

Supplier of bonds

= Demanders for loanable funds

Bonds

Funds

Buyer (Demander)

Lender who buys bond

Borrower raising funds

Seller (Supplier)

Borrower issuing bond

Lender supplying funds

Price

Bond price

Interest rate
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Supply and Demand in the Bond Market

A bond demand curve: the relationship between the

quantity demanded and the price when all other economic
variables are held constant.

A bond supply curve: the relationship between the quantity

supplied and the price when all other economic variables
are held constant.

At lower prices (higher interest rates), ceteris paribus, the

quantity demanded of bonds is higher: an inverse
relationship

At lower prices (higher interest rates), ceteris paribus, the

quantity supplied of bonds is lower: a positive relationship

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Market Equilibrium in the Loanable Funds Framework

Occurs when the amount that people are willing to buy (demand/ Bd)
equals the amount that people are willing to sell (supply/ Bs) at a given
price.

In the bond market :

when Bd = Bs (at point C) the equilibrium (market-clearing price)

When Bd < Bs : excess supply (I>A); people want to sell more bonds
than others want to buy, the price of bond will fall and interest rate will
rise.

Bond price = $850 (i=17.6%), quantity of bonds = $300 billion;

Price of the bonds is set too high ($950), quantity of bonds supplied
(point I) > quantity of bonds demanded (point A).

When Bd > Bs : excess demand ( E>F); people want to buy more bonds
than others are willing to sell, the price of bond will rise and interest rate
will fall.

Price of the bonds is set too low ($750), ), quantity of bonds supplied
(point F) < quantity of bonds demanded (point E).

This process will continue until equilibrium is reached at C

15

Figure 1 Supply and Demand for Bonds

16

Changes in Equilibrium Interest Rates in the Loanable

Funds Framework
Shifts in the demand for bonds:
in a business cycle expansion with growing wealth, the demand
for bonds rises and the demand curve for bonds shifts to the right. In a
recession, when income and wealth are falling, the demand for bonds falls,
and the demand curve shifts to the left.
1.Wealth

2.Expected

Returns:

a) Expected return on bonds: Higher expected interest rates in the

future lower the expected return for long-term bonds, decrease the
demand, and shift the demand curve to the left. Lower expected interest
rates in the future increase the demand for long-term bonds and shift the
demand curve to the right.
b) Expected return on other assets: Higher expected return on other
asset (shares is higher than bond), decrease the bond demand, and
shift the demand curve to the left, and vice versa.

c) Expected Inflation: An increase in the expected rate of inflations

lowers the expected return for bonds, causing their demand to decline and
the demand curve to shift to the left.

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Shifts in the demand for bonds:

3. Risk: an increase in the riskiness of bonds causes the
demand for bonds to fall and the demand curve to shift to
the left. An increase in the riskiness of alternative assets
causes the demand for bonds to rise and the demand curve
to shift to the right.
4. Liquidity: increased liquidity of bonds results in an increase
demand fir bonds, and the demand curve shifting right.
Increase liquidity of alternative assets lowers the demand
for bonds and shifts the demand curve to the left.

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Figure 2
Shift in the Demand Curve for Bonds

19

Summary Table 2
Factors That Shift the Demand Curve for Bonds

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Shifts in the Supply of Bonds

1. Expected profitability of investment opportunities:

2.

In a business cycle expansion, the supply of bonds

increases, and the supply curve shifts to the right.

In a recession, when far fewer profitable investment

opportunities are expected, the supply of bonds falls, and
curve shifts to the left.

Expected inflation:

3.

An increase in expected inflation causes the supply of

bonds to increase and the supply curve to shift to the right.

Government budget (Government borrowing):

Higher government deficits increase the supply of bond and

shift the supply curve to the right.

Government surpluses, decrease the supply of bonds and

shift the supply curve to the left.
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Shifts in the Supply of Bonds

4.

Business taxation

Investment activities (tax subsidies for investment),

increase the profitability of investment, increase firms
willingness to supply bond and shift the supply curve to the
right.

Higher tax burden on the profits earned by new investment

reduce firms willingness to supply bond, and shift the
supply curve to the left.

22

Figure 3
Shift in the Supply Curve for Bonds

23

Summary Table 3
Factors That Shift the Supply of Bonds

24

Analysis
1. Shift in demand for bonds / supply of the LF
(Supply is constant)
2. Shift in supply bonds / demand for LF
(Demand is constant)
3. Shift in both demand and supply of bonds/LF

25

Shifts in Both Demand and Supply of Bonds

1. Changes in the Interest Rate due to Expected Inflation:
The Fisher Effect (Expected inflation rise, the interest rate also rise)
Case 1: Increase in expected inflation
Figure 4 Response to a Change in Expected Inflation

At initial equilibrium, the supply of bond is at BS1 and the demand

for bond is at BD1. The equilibrium is at 1. The equilibrium bond
price is at P1 and the equilibrium interest rate is at i1.

If the expected inflation increases, the expected return on bond

relative to real assets falls. As a result, the demand for bonds falls,
and the demand curve shift to the left (from Bd1 to Bd2).

The rise in expected inflation also shifts the supply curve. At any
given bond price and interest rate, the real cost of borrowing has
declined, causing the quantity of bonds supplied to increase, and
the supply curve shifts to the right (from Bs1 to Bs2).

The equilibrium moves from point 1 to point 2, where the

equilibrium price of bond has fallen (from P1 to P2) because the
bond price is negatively related to the interest rate. This means
the interest rate has risen.

When expected inflation rises, interest rate will rise (Fisher

effect)
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Case 2: Decrease in expected inflation

At initial equilibrium, the equilibrium is at point 2. The

equilibrium bond price is at P2 and the equilibrium interest
rate is at i2.
If the expected inflation decreased, the real interest rate is
higher, cost of borrowing increased. The supply of bond
falls and the supply curve shift to the left (from Bs2 to Bs1).
Decrease in expected inflation will increase the expected
return on bonds. The demand for bond increase and the
demand curve shift to the right (from Bd2 to Bd1).

The equilibrium moves from point 2 to point 1, where the

equilibrium price of bond has fallen (from P2 to P1) because
the bond price is negatively related to the interest rate. This
means the interest rate has fallen.

When expected inflation falls, interest rate will fall

(Fisher effect)
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2. Changes in the Interest Rate due to a Business Cycle

Expansion / Contraction
Figure 6 Response to a Business Cycle Expansion
i

Case 1: Expansion in business cycle

During the business cycle expansion, aggregate output (the

amount of g&s) increases, so, national income rises.

Businesses will be more willing to borrow, because of positive

expected opportunities. The supply of bonds will increase, the supply
curve for bonds shifts to the right (from Bs1 to Bs2).

Expansion in the economy will also affect the demand for bonds.

Expansions in business cycle increase peoples wealth. Increase in

wealth means that people have a tendency to hold asset. The demand
for bond will increase. The demand curve for bond shift to the right
(from Bd1 to Bd2).

The equilibrium moves from point 1 to point 2, where the equilibrium price
of bond has fallen (from P1 to P2) because the bond price is negatively
related to the interest rate. This means the interest rate has risen.

During the business cycle expansion, the price of bond will

decrease and the interest rate will rise.
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Case 2:Contraction in Business Cycle

In a business cycle contraction, aggregate output decreases.

There are many unprofitable projects. The supply of bond
will fall. The supply curve will shift to the left (from Bs2 to Bs1).

In a business cycle contraction, peoples wealth decreases.

The demand for bond will fall. The demand curve will shift to
the left (from Bd2 to Bd1).

The price of bond will increase and the interest rate will fall.

During the business cycle contraction, the price of bond

will increase and the interest rate will fall.

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Supply and Demand in the Market for Money:

The Liquidity Preference Framework

The Liquidity Preference Framework was introduced by John

Maynard Keynes, in which equilibrium interest rate is
determined by the intersection of demand and supply of
money.

The Keynesian approach (liquidity preference) focuses on the

Ms and Md. Keynes assumes that there are two main
categories of assets that people use to store wealth: money &
bonds. The total wealth= total money + total quantity of
bonds in the economy.

According to Keynes, there are three main motives for

holding highly liquid money (READ MORE)

(1) The transactions motive,

(2) The precautionary motive and

(3) The speculative motive.

32

According to Keynes:
Money demand

Money supply
Ms

Md

Equilibrium r using Md=Ms.

Ms

Md
M

M
33

Determination of interest rate in the Liquidity Preference

Framework (Money demand and money supply

Figure 8 Equilibrium in the

Market for Money

34

Determination of Interest Rate in the Liquidity Preference

Theory (Money Demand and Money Supply Analysis)

Equilibrium in the market for money occurs at point C, the

intersection of the money demand curve (Md) and the money
supply curve (Ms).
The equilibrium interest i =15%.
If interest rate is at 25%, which is above 15%, the quantity of
money supplied ($300 billion) > the quantity of money demanded
($100 billion).
The excess supply of money means that people are holding
more money than they desire, so they will try to get rid of their
excess money balances by trying to buy bonds. Accordingly,
they will bid up the price of bonds. As the bond price rises, the
interest rate will fall toward the equilibrium interest rate of 15%.
If interest rate is 5%, the quantity of money demanded ($500 billion)
> the quantity of money supplied ($300 billion).
An excess demand for money exists because people want to
hold more money than they currently have. So people will sell
their only other asset-bonds-and price of bonds will fall. As the
price of bonds falls, the interest rate will rise toward the
35
equilibrium rate of 15%

Shifts in the Demand for Money

1. Income Effect / Business cycle fluctautions
In Keynesians view, there were 2 reasons why income
would affect the demand for money.

as an economy expands, income rises, wealth

increases and people will want to hold more money as
a store of value.

As an economy expands, income rises, people will

want to carry out more transactions using money, so
that they will hold more money.
Conclusion: A higher level of income causes the
demand for money to increase and demand curve shift
to the right.

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2. Price Level Effect / Inflation

In Keyness view, people care about the amount they hold in

real terms.

When the price level increases, the same nominal quantity

of money is no longer as valuable;

It cannot be used to purchase as many real goods or

services.

To restore the holdings of money in real terms to its former

level, people will want to hold a greater nominal quantity of
money.

Conclusion: An increase in the price level causes the

demand for money to increase and the demand curve shift
to the right.

37

Shifts in the Supply of Money

Assuming that the money supply is completely controlled by
the CB, which in Malaysia is Bank Negara Malaysia.

The changes in monetary policy implementation will shift

the supply curve to the left or to the right.

38

Changes in Equilibrium Interest Rates in the Liquidity

Preference Theory
1.

Changes in income

During business cycle expansion, income is rising. Demand for money

will rise.

Demand curve shift rightward.

Equilibrium interest rate rises from i1 to i2.

When income is rising during a business cycle expansion (holding other

economic variables constant, interest rates will rise)
2. Changes in the Price Level

When the price level rises, the value of money in terms of what it can
purchase is lower. People will want to hold a greater nominal quantity of
money.

The demand curve for money shifts to the right (from Md1 to Md2).

The equilibrium interest rate rises from i1 to i2.

When the price level increases, with the supply of money and other
economic variables held constant, interest rates will rise.

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Figure 9
Response to a Change in Income or the Price Level

40

3. Changes in the Money Supply

When government implemented expansionary monetary policy,

the money supply increases.

The supply curve shift to the right (from MS1 to MS2).

The equilibrium interest rate falls from i1 to i2.

When the money supply increases (ceteris paribus), interest rate

will decline.

41

Figure 10
Response to a Change in the Money Supply

42