Economics: Interest Rate Determination

Determinants of Bond Demand

• Wealth: an increase in wealth leads to a rise in the demand for bonds and a shift to the right of the demand curve
• Expected return:
  • Higher expected interest rates in the future lower the expected return for long-term bonds, decreasing demand and shifting the demand curve to the left
  • Changes in expected return on other assets (e.g., stocks, real assets) can also shift the demand curve for bonds
  • An increase in expected inflation lowers the expected return for bonds, causing demand to decline and the demand curve to shift to the left
• Saving: an increase in household saving leads to an increase in wealth, raising the demand for bonds and shifting the demand curve to the right

Interest Rate Determination in an Economic System

• The interest rate is determined through the interaction of the supply of funds (savings or loanable funds) and the demand for surplus funds (demand for loanable funds) in the credit market
• The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
• The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

Changes in Equilibrium Interest Rates

• Shifts in the demand for money:
  • Income effect: an increase in income causes the demand for money 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 to increase and the demand curve to shift to the right
• Keynes's liquidity preference analysis:
  • Individuals inherently prefer money among all financial assets
  • Interest is paid to persuade people to exchange their money for less liquid assets
  • There are three motives behind the general preference for holding highly liquid money: transaction, precaution, and speculation

Keynes's Motives

• Transaction motive:
  • Demand for money is positively determined by income
  • Interest rate does not have any influence on the demand for money
• Precautionary motive:
  • Demand for money is positively determined by income
  • Interest rate does not have any influence on the demand for money
• Speculative motive:
  • Demand for money is negatively influenced by interest rate
  • People may hold money balances in excess of their transactions and precautionary needs to take advantage of changes in bond prices

Risks, Liquidity, and Information Costs of Bonds

• Risks: 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
• Information costs: increased information on bonds results in an increased demand for bonds, and the demand curve shifts to the right

Learn about the factors that influence the demand and supply of assets, including risk and liquidity. Understand how the interest rate is determined through the interaction of supply and demand in the credit market.