Lecture 4: The Behaviour of Interest Rates

Introduction

We want to study the fluctuations of interest rates, for simplicity, the overall level of nominal
interest rates (simply interest rates). We find a negative relationship between interest rates
and the price of bonds in last lecture. We will use supply and demand analysis for markets
for bonds and money (assets) to study the change of interest rates.

An asset is a piece of property such as money, bonds, stocks, art, land, houses, etc., that is a
store of value. The theory of asset demand outlines criteria that are important when deciding
which assets are worth buying.

Determinants of Asset Demand

i. Wealth is the total resources owned by the individual, including all assets.
ii. Expected return on one asset relative to alternative assets.
iii. Risk (or the degree of uncertainly) on one asset relative to alternative assets.
iv. Liquidity (the ease and speed with which an asset can be turned into cash) relative to
alternative assets.

Wealth

Wealth increases implies that the quantity demanded for an asset increases.

% change in quantity demanded

Consider, Wealth elasticity of demand ( W ) = .
% change in wealth

W  1: That asset is a necessity. The percentage increase in the quantity demanded of

the asset is less than the percentage increase in wealth.

W > 1: That asset is a luxury. The percentage increase in the quantity demanded of the
asset is larger than the percentage increase in wealth.

Holding everything else constant, an increase in wealth raises the quantity demanded of an
asset, and the increase in the quantity demanded is greater if the asset is a luxury than if it is a
necessity.

Expected Returns

An increase in an asset’s expected return relative to that of an alternative asset because

i. expected return of asset, say X, increases while the return on an alternative asset Y
remains unchanged; or
ii. expected return of an alternative asset Y falls while the return on X remains unchanged.

An increase in an asset’s expected return relative to that of an alternative asset, holding

everything else unchanged, raises the quantity demanded of the asset.

1
Risk

Holding everything else constant, if an asset’s risk rises relative to that of alternative assets,
its quantity demanded will fall.
Fly-by-Night Minibus Feet-on-the-Ground Railways
(High-risk Stock) (Low-risk Stock)
Rate of Return 10% 10%

Since risk is a bad, people prefer lower risk as the degree of risk associated with this stock is
lower, other things being equal.

Liquidity

The more liquid an asset is relative to alternative assets, holding everything else unchanged,
the more desirable it is, the greater will be the quantity demanded.
For Example, government bonds vs. house.

Loanable Funds Framework: Supply and Demand in the Bond Market

(F - Pd )
Let us consider the demand for one-year discount bonds with i = RETe =
Pd
where i = interest rate = yield to maturity
RETe = expected returns
F = face value of the discount bond
Pd = initial purchase price of the discount bond

Pd 1000 950 900 850 800 750

i (%) 0 5.3 11.1 17.6 25.0 33.0
Q Bd 100 200 300 400 500
QBS 500 400 300 200 100

Supply and Demand for Bonds

2
 A Comparison of Loanable Funds and Supply and Demand for Bonds Terminology

Demand for Bonds = Supply of Loanable Funds

Supply of Bonds = Demand for Loanable Funds

Changes in Equilibrium Interest Rates

Change in quantity demanded, movements along a demand curve, Pd ↓ ( i ↑ ) => Bdq ↑

Change in quantity supplied, movements along a supply curve, Pd ↑ ( i ↓ ) => Bsq ↑

Shifts in the Demand for Bonds

1. Wealth
2. Expected returns on bonds relative to alternative assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets

Wealth

When the economy is growing rapidly in a business cycle expansion and wealth is increasing,
the demand for bonds rises and the demand curve for bonds shifts to the right.

P Bd1 Bd2

Quantity of Bonds

3
Expected Returns

i. Higher expected Expected return on

→ → Bd shifts to the left
interest rates long-term bonds ↓

P Bd2 Bd1

Quantity of Bonds

ii. Expected returns on Expected return on

→ → Bd shifts to the left
other assets ↑ bonds ↓

P B d2 B d1

Quantity of Bonds

iii. Expected Expected return on Expected returns Bd shifts to

→ → →
Inflation ↑ physical assets ↑ on bonds ↓ the left

P B d2 B d1

Quantity of Bonds

Risk

An increase in the riskiness of bonds causes the demand for bonds to fall and the demand
curve to shift to the left.

Liquidity

Increased liquidity of bonds results in an increased demand for bonds, and the demand curve
shifts to the right.

4
Shifts in the Supply of Bonds

1. Expected profitability of investment opportunities

2. Expected inflation
3. Government activities (e.g., government deficits)

Expected profitability of investment opportunities

The more profitable investments that a firm expects it can make, the more willing it will be to
borrow and increase the amount of its outstanding debt in order to finance these investments.

e.g., Business More profitable firms supply of bonds ↑

cycle → investment → borrow → BS shifts to
expansion opportunities more the right

Expected Inflation

Since Real Interest Rate = Nominal Interest Rate – Expected Inflation, for a given (nominal)
interest rate, then we have

Expected real cost of firms borrow

→ → → Supply of bonds ↑
inflation ↑ borrowing ↓ more

Government Activities

If the government is involved in many activities, it may borrow more for expenditure.

Government deficits ↑ → supply of bonds ↑

5
Applications

1 Changes in Expected Inflation ( πe )

expected return on bonds relative to real assets

πe↑ → → Bd shifts to the left
↓
πe↑ → real cost of borrowing ↓ → BS shifts to the right

Results: Price of bonds ↓ and i ↑

But the effects on quantity of bonds are ambiguous.

When expected inflation rises, interest rates will rise.

This is called the Fisher effect.

2. Business Cycle Fluctuation

hghgghg

More profitable
Economy BS shifts to
→ investment → firms borrow more →
expands the right
opportunities
Economy
→ wealth ↑ → Bd shifts to the right
expands

6
Results: Quantity of bonds ↑
But the effects on price of bonds and i are ambiguous.

However, i is observed pro-cyclical. This suggests that the loanable funds framework fails to
explain the pro-cyclical behaviour of i.

Interest Rate
(% annual rate)

Shaded areas indicate that the business cycle is undergoing recessions.

Liquidity Preference Framework: Supply and Demand in the Market for Money

The liquidity preference framework determines the equilibrium interest rate in terms of the
supply of and demand for money.

Assumption

Two types of assets: Money and Bonds

Then we have: Wealth = Money + Bonds

Equilibrium condition

BS + MS = Bd +Md

The quantity of bonds and money supplied must equal the quantity of bonds and money
demanded.

It implies that BS – Bd = Md –MS

Hence, if BS = Bd then MS = Md

7
Money Demand (Md)

As interest rate on bonds, i, rises, the opportunity cost of holding money rises, and so money
is less desirable and quantity of money demanded must fall.

Md
Quantity of Money

Money Supply (MS )

At this level, we assume that a central bank controls the amount of money supplied, it is
exogenous.
i MS

Quantity of Money

Money Market Equilibrium

excess supply of money → people buy more bonds → bond price ↑→ i ↓

excess demand of money → people sell bonds to get money, bond price ↓→ i ↑

8
Shifts in the Demand for Money (Md)

Income Effect

1. An economy expands
 (income and wealth ) 
 people will hold money as a store of value.

2. An economy expands
 income 
 transaction 
 more money will be held by people.

Hence, Md shifts to the right. Income ↑

Price-level Effect

Price-level 
 quantity of money in real terms 

To restore holdings of money in real terms to its former

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

Hence, a rise in the price level causes the demand for money
to increase and the demand curve to shift to the right.

Price ↑

Shifts in the Supply of Money (Ms)

Liquidity effect: MS   i 

An increase in the money supply will shift the supply curve

for money to the right.

MS ↑

Other Effects(MS):

1. Income effect: MS   income  and wealth   i 

2. Price effect: MS   overall price level   i 
3. Expected Inflation effect: MS   expected inflation   i  (from the loanable
funds framework)

9
Does a Higher Rate of Growth of MS cause lower i ?

Income Effect
Liquidity Effect vs. Price-level Effect
Expected Inflation

The Liquidity Effect from the greater money growth takes effect immediately because the
rising money supply leads to an immediate decline in the equilibrium interest rate.

The income and price-level effects take time to work because the increasing money supply
takes time to raise the price level and income, which in turn raises interest rates.

The expected-inflation effect, which also raises interest rates, can be slow or fast.

Three Possibilities

10