Transcript PowerPoint Presentation - The Behavior of Interest Rates

Lecture 12
The Behavior of
Interest Rates
5.5-1
Derivation of Demand Curve
e
(F – P)
i = RET =
P
———
Point A:
P = $950
($1000 – $950)
i =—————— = .053 = 5.3%
$950
Bd = 100
5.5-2
Derivation of Demand Curve
Point B:
P = $900
($1000 – $900)
i =—————— = .011 = 11.1%
$900
d
B
= 200
d
Point C: P = $850 i = 17.6% B = 300
d
Point D: P = $800 i = 25.0% B = 400
d
Point E: P = $750 i = 33.0% B = 500
d
Demand Curve is B in Figure 1 which connects points A, B, C, D, E.
Has usual downward slope
5.5-3
Supply and Demand Analysis of the Bond Market
5.5-4
Derivation of Supply Curve
Point F:
s
P = $750 i = 33.0% B = 100
s
Point G: P = $800 i = 25.0% B = 200
s
Point C: P = $850 i = 17.6% B = 300
s
Point H: P = $900 i = 11.1% B = 400
Point I:
s
P = $950 i = 5.3% B = 500
s
Supply Curve is B that connects points F, G, C, H, I,
and has upward slope
Market Equilibrium
d
s
1. Occurs when B = B , at P* = 850, i* = 17.6%
s
d
2. When P = $950, i = 5.3%, B > B (excess supply): P  to P*, i  to i*
d
s
3. When P = $750, i = 33.0, B > B (excess demand): P  to P*, i  to i*
5.5-5
Loanable Funds Terminology
1. Demand for
bonds = supply
of loanable
funds
2. Supply of
bonds =
demand for
loanable funds
5.5-6
Shifts in the Demand Curve
5.5-7
Theory of Asset Demand
1. Wealth
A. Economy , wealth , Bd , Bd shifts out to right
2. Expected Return
A. i  in future, RETe for long-term bonds  , Bd shifts out
to right
B. pe , Relative RETe  , Bd shifts out to right
3. Risk
A. Risk of bonds , Bd  , Bd shifts out to right
B. Risk of other assets , Bd , Bd shifts out to right
4. Liquidity
A. Liquidity of Bonds , Bd  , Bd shifts out to right
B. Liquidity of other assets , Bd ,Bd shifts out to right
5.5-8
Factors
that
Shift
Demand
Curve
5.5-9
Shifts in the Supply Curve
1. Profitability of
Investment Opportunities
A. Business cycle
expansion,
investment
opportunities  , Bs  ,
Bs shifts out to right
2. Expected Inflation
A. pe  , Bs  , Bs shifts
out to right
3. Government Activities
A. Deficits  , Bs  , Bs
shifts out to right
5.5-10
Factors that Shift Supply Curve
5.5-11
Changes in pe: the Fisher Effect
If pe 
1. Relative RETe
, Bd shifts in to
left
2. Bs , Bs shifts
out to right
3. P , i 
5.5-12
Evidence on the Fisher Effect
in the United States
5.5-13
Business Cycle Expansion
1. Wealth , Bd , Bd
shifts out to right
2. Investment , Bs ,
Bs shifts right
3. If Bs shifts more
than Bd then P , i 
5.5-14
Evidence on Business Cycles and Interest Rates
5.5-15
Response to a Low Savings Rate
5.5-16
Relation of Liquidity Preference
Framework to Loanable Funds
Keynes Major Assumption
Two categories of assets in wealth
1. money
2. bonds
1. Thus:
Ms + Bs = Wealth
2. Budget Constraint:
Bd + Md = Wealth
3. Therefore:
Ms + Bs = Bd + Md
4. Subtracting Md and Bs from both sides:
Ms – Md = Bd – Bs
Money Market Equilibrium
5. Occurs when Md = Ms
6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd = Bs and
bond market is also in equilibrium
5.5-17
1. Equating supply and demand for bonds as in
loanable funds framework is equivalent to
equating supply and demand for money as in
liquidity preference framework
2. Two frameworks are closely linked, but differ in
practice because liquidity preference assumes only
two assets, money and bonds, and ignores effects
from changes in expected returns on real assets
5.5-18
Liquidity Preference Analysis
Derivation of Demand Curve
1. Keynes assumed money has i = 0
e
2. As i  , RET on money  (equivalently, opportunity cost of
d
money  )  M 
3. Demand curve for money has usual downward slope
Derivation of Supply curve
s
1. Assume that central bank controls M and is a fixed amount
s
2. M curve is vertical line
Market Equilibrium
d
s
1. Occurs when M = M , at i* = 15%
s
d
2. If i = 25%, M > M (excess supply): Price of bonds  ,
i  to i* = 15%
d
s
3. If i =5%, M > M (excess demand): Price of bonds  ,
i  to i* = 15%
5.5-19
Money Market Equilibrium
5.5-20
Rise in Income
1. Income , Md , Md
shifts out to right
2. Ms unchanged
3 i* rises from i1 to i2
5.5-21
Rise in Price Level
1. Price level , Md , Md
shifts to right
2. Ms unchanged
3. i* rises from i1 to i2
5.5-22
Rise in Money Supply
1. Ms , Ms shifts out to
right
2. Md unchanged
3. i* falls from i1 to i2
5.5-23
Factors
that Shift
Money
Demand
and Supply
Curves
5.5-24
Money and Interest Rates
Effects of money on interest rates
1. Liquidity Effect
Ms  , Ms shifts right, i 
2. Income Effect
Ms  , Income  , Md  , Md shifts right, i 
3. Price Level Effect
Ms  , Price level  , Md  , Md shifts right, i 
4. Expected Inflation Effect
Ms  , pe  , Bd , Bs  , Fisher effect, i 
Effect of higher rate of money growth on interest rates is
ambiguous
1. Because income, price level and expected inflation effects work
in opposite direction of liquidity effect
5.5-25
Does Higher
Money
Growth
Lower
Interest
Rates?
5.5-26
Evidence on Money Growth and Interest Rates
5.5-27
Supply and Demand in Gold Market
Deriving Demand Curve
e
RET =
P+1 – Pt
————— = g
Pt
1. P is held constant
+1
e
d
2. Pt , g , RET   G 
3. Demand curve is downward sloping
Deriving Supply Curve
s
1. Pt , more production, G 
2. Supply curve is upward sloping
Market Equilibrium
d
1. G = G
s
s
d
s
d
2. If Pt > P* = P1, G > G , Pt  to P*
3.. If Pt < P* = P1, G < G , Pt  to P*
5.5-28
Changes in Equilibrium Factors that Shift
Demand Curve for Gold
1. Wealth
2. Expected return on gold relative to alternative
assets
3. Riskiness of gold relative to alternative assets
4. Liquidity of gold relative to alternative assets
Factors that Shift Supply Curve for Gold
1. Technology of mining
2. Government sales of gold
5.5-29
Response of Gold Market to a Change in pe
If pe 
[Figure A-1 here]
1. pe , P+1 ; at given
Pt, g   Gd   Gd
shifts right
2. Go to point 2; Pt 
3. Price of Gold
positively related to
pe
4. Gold price is
barometer of
p-pressure
5.5-30