Behavior of Interest Rates Handout PDF

Preview Monetary Economics ECN 3104 Before In this chapter, we examine how the overall. level of nominal interest rates is determined...

Preview Monetary Economics ECN 3104 Before In this chapter, we examine how the overall. level of nominal interest rates is determined and which factors influence their behavior. CHAPTER 5 The Behavior of Interest Rates 1 2 Learning Objectives Learning Objectives üDescribe the connection between the bond market and üIdentify the factors that affect the demand for assets. the money market through the liquidity preference üDraw the demand and supply curves for the bond framework. market and identify the equilibrium interest rate. üList and describe the factors that affect the money üList and describe the factors that affect the equilibrium market and the equilibrium interest rate. interest rate in the bond market. üIdentify and illustrate the effects on the interest rate of changes in money growth over time. 3 4  Determinants of Asset The Theory of Portfolio Demand Choice Holding all other factors constant: The quantity demanded of an asset is positively related to wealth Economic agents hold a variety of different assets. What are the primary assets you hold? The quantity demanded of an asset is positively related to its expected return relative to alternative An asset is anything that can be owned and has assets value. 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 5 6 The Theory of Portfolio Supply and Demand in the Choice Bonds Market Summary Table 1 At lower prices (higher interest rates), ceteris paribus, the Response of the Quantity of an Asset Demanded to Changes in Wealth, quantity demanded of bonds is higher: an inverse Expected Returns, Risk, and Liquidity relationship At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship Note: Only increases in the variables are shown. The effects of decreases in the variables on the quantity demanded would be the opposite of those indicated in the rightmost column. 7 8  Figure 1 Supply and Market Equilibrium Demand for Bonds Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. Bd = Bs defines the equilibrium (or market clearing) price and interest rate. When Bd > Bs , there is excess demand, price will rise and interest rate will fall. When Bd < Bs , there is excess supply, price will fall and interest rate will rise. 9 10 Changes in Equilibrium Figure 2 Shift in the Interest Rates Demand Curve for Bonds Shifts in the demand for bonds: Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity: increased liquidity of bonds results in the demand curve shifting right 11 12  Shifts in the Demand for Bonds Shifts in the Supply of Bonds (1 of 2) Shifts in the supply for bonds: Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the Summary Table 2 right Government budget: increased budget deficits shift the supply curve to the right 13 14 Shifts in the Supply of Bonds (2 of 2) Figure 3 Shift in the Supply Curve for Bonds Summary Table 3 15 16  Figure 4 Response to a Change in Figure 5 Expected Inflation and Interest Rates Expected Inflation (Three-Month Treasury Bills), 1953–2017 Sources: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3M; https://fred.stlouisfed.org/series/CPIAUCSL.S. Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An EmpiricalInvestigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends. 17 18 Figure 6 Response to a Figure 7 Business Cycle and Interest Business Cycle Expansion Rates (Three-Month Treasury Bills), 1951–2017 Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS 19 20  Supply and Demand in the Market for Figure 8 Equilibrium in the Market Money: The Liquidity Preference for Money Framework (1 of 2) Keynesian model that determines the equilibrium interest rate in terms of the supply of and demand for money. There are two main categories of assets that people use to store their wealth: money and bonds. Total wealth in the economy = Bs + Ms = Bd+ Md Rearranging: Bs − Bd = Ms − Md If the market for money is in equilibrium (Ms = Md ), then the bond market is also in equilibrium (Bs = Bd ). 21 22 Supply and Demand in the Market for Changes in Equilibrium Interest Rates Money: The Liquidity Preference in the Liquidity Preference Framework (1 of 3) Framework (2 of 2) Shifts in the demand for money: Income Effect: a higher level of income causes the demand Demand for money in the liquidity preference for money at each interest rate to increase and the demand framework: curve to shift to the right The rises in income cause wealth to increase As the interest rate increases: People need to carry out more transactions The opportunity cost of holding money increases… Price-Level Effect: a rise in the price level causes the The relative expected return of money decreases… demand for money at each interest rate to increase and the …and therefore the quantity demanded of money demand curve to shift to the right decreases. People care about their money of holding in real terms 23 24  Changes in Equilibrium Interest Rates Changes in Equilibrium Interest Rates in the Liquidity Preference Framework in the Liquidity Preference Framework (3 of 3) (2 of 3) Shifts in the supply of money: Assume that the supply of money is controlled by the central bank. An increase in the money supply engineered by the Federal Summary Table 4 Reserve will shift the supply curve for money to the right. 25 26 Figure 9 Response to a Change in Figure 10 Response to a Change in Income or the Price Level the Money Supply 27 28  Does a Higher Rate of Growth of the Money and Interest Rates Money Supply Lower Interest Rates? (1 of 2) A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices. Liquidity preference framework leads to the Price-level effect remains even after prices have stopped conclusion that an increase in the money supply will rising. lower interest rates: the liquidity effect. A rising price level will raise interest rates because people Income effect finds interest rates rising because will expect inflation to be higher over the course of the increasing the money supply is an expansionary year. When the price level stops rising, expectations of inflation will return to zero. influence on the economy (the demand curve shifts to the right). Expected-inflation effect persists only as long as the price level continues to rise. 29 30 Figure 11 Response over Time to an Does a Higher Rate of Growth of the Increase in Money Supply Growth Money Supply Lower Interest Rates? (2 of 2) Price-Level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right). Expected-Inflation effect shows an increase in interest rates because an increase in the money supply may lead people to in the future (the demand curve shifts to the right). expect a higher price level 31 32  Figure 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2017 Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/series/TB3MS 33