Eco 531 Chapter 4: Interest Rate Behavior PDF

ECO 531- CHAPTER 4 THE BEHAVIOR OF INTEREST RATE OBJECTIVES OF THE LESSON  Interest Rates, Rate of Returns and Price of Bond  Real and Nominal Interest Rates  Theories on the Determination of Interest Rates (i) Classical Model (bond market) (ii) Keynesian Model (money market) INTEREST RATE...

ECO 531- CHAPTER 4 THE BEHAVIOR OF INTEREST RATE OBJECTIVES OF THE LESSON  Interest Rates, Rate of Returns and Price of Bond  Real and Nominal Interest Rates  Theories on the Determination of Interest Rates (i) Classical Model (bond market) (ii) Keynesian Model (money market) INTEREST RATE  Important variable in the economy.  Are reported almost daily by the news media, because it directly affect our everyday lives and have important consequences for the health of the economy.  It affect personal decisions such as whether to consume or save, whether to buy a house, and whether to purchase bonds or put funds into savings account.  Interest rates play important role in our life and in the general economy. For the borrower, interest rate is a payment for obtaining credit (loan) or the cost of borrowing for rental of funds, expressed as a percentage per year. For the lender, it is the amount of funds, that they receive when they extend credit. It is a reward for delaying their current consumption. MEASURING INTEREST RATE  Yield to maturity (YTM) is the most accurate measure of interest rate.  YTM also refer to the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.  i.e we are equating today’s value of the debt instrument with the present value of all of its future cash flow payments.  YTM is also called the internal rate of return.  Bond’s i/rate does not necessarily indicate how good an investment the bond is, because what the bond earns (its rate of return) does not necessarily equal its interest rate. COUPON BOND  To know the concept of YTM, we can use coupon bond as an example.  A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures.  Its identified by four pieces of information:  First is the bond’s face value -> RM1000 10 % 10tahun matured + dpt every year 10 %, 10th year apt 10 % face value .  Second is the corporation or government agency that issues the bond - capital market instruments such as Treasury bonds and notes and Corporate bonds ↳ government  Third is the maturity date of the bond ↳ company  Fourth is the bond’s coupon rate - which is the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond. COUPON BOND In our example: the coupon bond has a yearly coupon payment of $100 and a face value of $1000. The coupon rate is then $100/$1000 = 0.10 or 10%. It pays the owner of the bond a fixed interest payment - coupon payment - every year until maturity date, when a specified final amount - face value/par value - is repaid. PRICE OF BOND  Price of bond and YTM are negatively related.  When the interest rate rises, the price of the bond falls. increase Price of bond ($) Yield to maturity (%) 1200 1100 1000 900 800 7.13 8.48 10.00 11.75 13.81 will decrease  When the coupon bond is priced at its face value, the YTM equals the coupon rate.  The YTM is greater than the coupon rate when the bond price is below its face value.  The price of a coupon bond and the YTM are negatively related; that is, as the YTM rises, the price of the bond falls. As the YTM falls, the price of the bond rises. RATES OF RETURN (ROR)  ROR are basically return on investment or reward of taking risks. Ex. return on stocks,bonds,saving,etc.  ROR is defined as a payment to the owner of a security (dividend paid) plus the change in the value of the security (appreciation in value), expressed as a fraction of its purchase price.  i.e - use the same example as coupon bond - $1000 with 10% - held for one year, and then sold for $1200 (decided to sell at higher value @1200), the payments to the owner are the yearly coupon payments of $100.  ::The change in the bond’s value is $1200 - $1000 = $200.  Adding this value together and expressing them as a fraction of the purchase price of $1000 gives us the one-year holding-period return for this bond:  $200 + $100 = 0.30 = 30% $1000 ROR is defined as a payments to the owner plus the change in its value. THE DISTINCTION BETWEEN NOMINAL AND REAL INTEREST RATE Nominal -> market or current price  So far in our discussion of i/rate, we have ignored the effects of inflation on the cost of borrowing.  What we up to this point have been calling the i/rate makes no allowance for inflation – more precisely referred to as the nominal i/rate.  Nominal rate is the rate of interest that is accrued at some time in the future - simply ‘returns’.  It is the rate of exchange between RM now and RM in the future.  For ex., 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. in reality , Real lender -> - rugi good always a bit lower than interest rate .  The interest rate that is adjusted by subtracting expected changes in the price level (inflation), so that it more accurately reflects the true cost of borrowing.  Real = Nominal - 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, 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. Real i/rate which reflects the real cost of borrowing is likely to be a better indicator of the incentives to borrow and lend. Be a better guide to how people will respond to what is happening in credit markets. DETERMINING THE QUANTITY DEMANDED OF AN ASSET  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. An increase in wealth raises the quantity demanded of an assets. ❑ Expected Return right - the return expected over the next period on one asset relative to alternative hift in asset’s expected return relative to that of an alternative asset, raises the assets. Increase quantity demanded of the assets. to ❑ Risk - the degree of uncertainty associated with the return on one asset relative to alternative assets.If asset’s risk rises relative to that of alternative assets,quantity demanded will fall. ❑ Liquidity - the ease and speed with which an asset can be turned into cash relative to alternative assets. The more liquid an assets, the more desirable it is, the greater will be the quantity demanded. ❑ (+) Information gathered ❑ (+) Cost information Deficit (xculup duit) issue bond to get fund . THEORY OF ASSET DEMAND  Holding all other factors constant: ceteris Dua peribus dua Sama naik ❑ The quantity demanded of an asset is positively related to wealth ❑ The quantity demanded of an asset is positively related to its expected return relative to alternative assets Satu naile , sath a lean turun ❑ 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 RATE • Interest rate will change if there are changes in demand or supply curves of loanable fund. • The factors that influence the 1. demand curve to shift: Wealth - when economy is growing in business cycle expansion, wealth is increasing. The quantity of bond demanded increase. The demand curve will shift to the right. During recession, income and wealth decreasing. The demand for bonds declined. The demand curve will shift to the left. 2. Expected Returns: i) Expected return on bonds - if people think that interest rate will be higher in the future (savings), it means that the expected returns for long-term bonds will be lower. So, the demand for long-term bond will decrease. The demand curve will shift to the left. • In contrast, if the expected returns on bonds increase, bonds become a more attractive investment.Then the DD for bonds …. • But this is not the only change in the DD for bonds that occurs when expected returns rise. Bond DD is also affected by changes in the…… ii) Expected returns on other assets • For example, if investors become more optimistic about business prospects, expected capital gains on stocks are higher. At the same time, if the expected return on bonds do not change, DD for bonds will be reduce.The demand curve will shift to the left. iii) Expected Inflation - an increase in the expected rate of inflations lowers the expected return for bonds, causing their demand to decline and to shift demand curve to the left. • An increase in expected inflation raises expected future prices of physical assets (houses, cars, commodities), implying nominal capital gains and higher expected returns from holding these assets. • If the expected return on bonds does not change, a rise in the expected return on physical assets reduces the expected return on bonds relative to that on physical assets, causing the DD for bonds to fall and shift to the left. 3. Risk – if prices of bonds volatile, the riskiness of bond increase, the bond is less attractive. The demand for bond decrease and the demand curve shift to the left. If price of the other asset become volatile, bond is more attractive. The demand for bond increase and the demand curve shift to the right. 4. Liquidity – if the bond is easier to sell, the quantity of bond demanded increased. Increased liquidity of bonds will increase the demand for bonds and the demand curve will shift to the right. 5. Costs information – is the cost associated in acquiring information on bonds, i.e. cost of travelling, research, time and more importantly is the accuracy of the information. Increased the cost resulted the demand for bond will be declined. \ 6. While, increased information resulted an increased in the demand for bond. Borrowerc  The factors that influence the -> good people a y supply curve to shift: fund 1. Expected profitability of investment opportunities – if the investment is profitable, the firms are willing to borrow in order to finance the investment. The quantity of bonds supplied increased.  In an expansion, investment opportunities are expected to be profitable. Supply of bond increase and the supply curve shifts to the right.  If the economy facing recession, the expected profitable investment are low, supply of bond decrease and the supply curve shift to the left. ~ products ↑P proce e -good : mpply ↑ more bond 2. Expected inflation – if the expected inflation increased, the real interest rate falls. The cost of borrowing decreased. The supply of bond increase and supply curve shift to the right.  But, if the expected inflation decreased, the real interest rate is higher. The cost of borrowing increased. It will reduce the supply of bond and the supply curve shift to the left.  In other word, an increase in the expected inflation reduces the value of existing bonds and raises borrowers’ willingness to supply bonds at any bond price. Then the SS curve shifts to the right. E . I . Y ↳s ↑ / DB N contra to SS shif right . 3. Government activities/borrowing – decision by governments can affect bond prices and interest rates in the economy. When government is in deficit, the BNM will issue bond to nampale finance the deficit. graph barn  - bilalulis The supply of bond increased and the supply curve shift to the right, ( reducing the price of bonds and increasing the interest rate. S  When government have surplus, they will reduce the supply of bond in market, the supply curve shift to the left. Government deficit-> supply more bond . Good - not for good government business for 4. Business taxation – investment incentives such as tax subsidies for investment, increase the profitability of investment thus increase firm’ willingness to supply bonds and shift the supply curve to the right. - Conversely, higher tax burdens on the profits earned by new investment reduce firms’ willingness to supply bond and shift the supply curve to the left.  * ⑦ > # Supply bond supply Incentive : by tax reduced tax exemption tax reduction tax subsidy 3 tinggi Shift Encourage firm menyebablear left to to 0 . increase investment (mppy) + curve shift to right . ada both ↑supply4 demand ex-Draw the market equilibrium MARKET EQUILIBRIUM  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.  When Bd = Bs : the equilibrium; price of bond and interest rate are determined.  When Bd > Bs : excess demand ( E>F); price of bond will rise and interest rate will fall.  When Bd < Bs : fall and interest rate will rise. excess supply (I>A); price of bond will Bond Equilibrium market A i/r SB0 - Ex : Question Refering explain reach : to diagram , how market equilibrium Pi (smarks) V ~ - 2 ~ v L ~ W ~ - Po x i - x t N P2 T 1 , 7 harga rendah rendah supply , DBO , demand tingg ; V Qu 0 negatively related SS&DD IN THE BOND MARKET AND LOANABLE FUNDS We can view the buyer (demander) of bonds and the seller/issuer (supplier) of bonds in 2 ways. -> supply + borrower 1. Bonds as the “good”. ↳DDB  : lender In this case, the lender is buying the bond and the borrower is selling the bond. The amount the lender pays for the bond is the price of the bond. -> supply lender 2. Funds as the “good”. ↳ duit/credit ▪ * DDloan : orgyde duit In this case, the borrower is the buyer because the borrower purchases the use of the funds and pays for it with a promise to repay. The seller is the supplier of the funds. The price of the funds exchanged is the interest rate. Sun Salanmintal e graph - Supply Demand 8 Wealth ② of Risk of ~Bot maintain sbb effect Lom ~ ↳ * Risk of Bond i 0 Don to Q of Boud Pi Qu ↳ t ↳ DBI ① Wealth ② DDY ③ Effects Qo - to Shift : P A Q ↑ i/r right from from ↓ il D BO Q ① , Qo from -> io ⑤ E Q, to is left from Pr ① 1 ↑ Bo of Q Bond si * Bra Q , Qo , Boud EI4 ② SSA Risk ② DDN Pots P of ⑪ expansion economy ↓ iO W Bond · si Demand of il &. Bond ④ Business taxation ↑ inflation . Expected ⑤ Bond ↑ /r i for Bond ↑ Pof Bond - for ⑤ E R PA ① ↓ i ↑ ① B ② SSB ↓ ⑤ E . . T . left PY ① tr it ↳Q of Boud SS&DD IN THE BOND MARKET AND LOANABLE FUNDS DD SS Price Bond is the good Lender who buys bond Borrower issuing bond Bond price Fund is the good Borrower raising funds Lender supplying funds Interest rate SHIFT IN BOTH DEMAND AND SUPPLY OF BOND ❑ Changes in expected inflation ❑ Fisher effect: expected inflation rise, the nominal interest rate also rise (but the real interest rate fall) A. Expected Inflation effect - Increase / Decrease B. Business cycle effect - Expansion / Contraction sangs spiy ot 31OCT : Clip 3 < goods A1: INCREASE IN EXPECTED INFLATION DD for bond • Interest rate forecasts pay attention to surveys about any signs of expected inflation. • When inflation, lenders realize that at any given bond price (or interest rate), the expected real return from lending has fallen. • It lower the expected return for bonds, therefore they decrease their willingness to hold bonds (lenders reduce their DD for bonds). • Causing demand to shift to the left to D1. • Conclusion: The bond DD curve shifts to the left, in response to the lower expected return. P CONT’D.. SBo ene "co Can iP PV • ↳ - need more money , , Gremain iO an i , Qu SS of bond i /w SBI -> e constant at W S Q Qo . . Borrowers view the increase in expected inflation differently. & • For them, at any given bond price (or interest rate), the real cost of borrowing has fallen. • As a consequence, the quantity of bonds supplied rises at any given bond price. • The bond SS curve shifts to the right to S1.  Conclusion: The bond SS curve shifts to the right, in response to the lower cost of borrowing. A2: DECREASE IN EXPECTED INFLATION DD for bond  Decrease in expected inflation will increase the expected return on bonds. The demand for bond increase and the demand curve shift to the right to D1. SS of bond  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 to S1. B1: EXPANSION IN BUSINESS CYCLE Economy is growing -> DDBondY , curve shift to right . DD for bond  Expansions in business cycle increase people’s wealth. Increase in wealth means that people have a tendency to hold asset.  The demand for bond increased and the demand curve for bond shift to the right to D1. SS of bond  During the business cycle expansion, aggregate output increase. So, national income increased. There are many profitable investments. It will encourage people to borrow and invest.  The supply of bond increased. The supply curve shifts to the right to S1. ❖ Effect: price of bond falls, interest rate rises. (Clip S( I case , big changes , supply ⑧ parallel gap is bigger than demand . Slow economy : effect greater than demand . B2: CONTRACTION IN BUSINESS CYCLE DD for bond  Business cycle contraction decreased the people’s wealth.  The demand for bond decrease and the demand curve shift to the left to D1. SS of bond  Contraction in business cycle reduced the aggregate output. There are many unprofitable projects.  The supply of bond falls and the supply curve shift to the left to S1 ❖ Effect: price of bond rises, interest rate falls (according to theory). THE LIQUIDITY PREFERENCE FRAMEWORK  The Liquidity Preference Framework by Keynes determined the interest rate by the intersection of demand and supply of money (in Money Market).  According to Keynes: t by Money demand Money supply control : -fixed i/r Equilibrium r using Md=Ms. ⑧ THEORY OF MONEY DEMAND:  KEYNES’ demand for money includes demand for idle cash (currency and demand deposits).  3 motives of holding money: 1. Transactionary motive 2. Precautionary motive 3. Speculative motive 1. TRANSACTIONARY MOTIVE (DMT)  Very importance motive for consumer expenditures and business transaction  Household demand for purchase g&S.  Firms demand for purchase pf that supply by Household  Demand for this motive depends on income level  As income increase, DMt also increase (+ve relationship) 2. PRECAUTIONARY MOTIVE (DMP)  DD for money also used for saving or for unpredictable problems in the future.  Money may used to pay for hospital bill if accident or use when individual resign from their work.  DD for this motive also depends on Yd.  As income increase, DMp also increase (+ve relationship) -> depend interest rate 3. SPECULATIVE MOTIVE (DMS) ↓ investment  Individual DD for money for the purpose of speculation.  They buy share and bond to get the profit  Speculative motive exist when people choose either want to hold money without any interest rate or invest it and get more income.  People will buy bond when they expect interest rate will decrease and price increase in the future  Otherwise, people will sell bond when they expect interest rate will increase and price decrease in the future.  So, DMs is depends on interest rate.  When interest rate is high, DMs will be lower (-ve/inverse relationship) Quiz Sampai sini . FACTORS THAT INFLUENCED MONEY MARKET: 1. Changes in income 2. Changes in the price level 3. Changes in the money supply 1. INCOME EFFECT 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. ✓ (DMP) -is As an economy expands, income rises, people will want to carry out more transactions using money, so that they will hold more money. CDMT) ✓ ❑ Conclusion: a higher level of income causes the demand for money to increase and demand curve shift to the right. ① Income ↑ , md' and t , - Qu of money R  During business cycle expansion, income is rising. Demand for money will rise.  Demand curve shift rightward.  Equilibrium interest rate rises from i1 to i2. 2. PRICE LEVEL EFFECT • Keynes took the view that people care about the amount of money they hold in real terms – that is, in terms of the g&s it can buy. • 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. ·/ r ↑ - Windo is i8 ② P4 MS - - Qu ma , > of money , md ↑  When the price level rises, the value of money in terms of what it can purchase is lower. People will want to hold more money.  The demand curve for money increase. The demand curve shifts to the right from Md1 to Md2.  The equilibrium interest rate rises from r1 to r2. 3. CHANGES IN THE MONEY SUPPLY  Supply of money is totally controlled by the central bank, 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. ⑤ msY . Expansion m/policy · ① if rate inflation expected to ·/ r ↑ mS MSI Emdo Exp inf Gor buy mdN in is ④ Go a, > G of money bond from expansionary my public; increase job ↓ , y ↓ unemployment & MSP -  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 r1 to r2.  TQ