Professional Documents
Culture Documents
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.
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.
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
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.
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.
(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
2
A Comparison of Loanable Funds and Supply and Demand for Bonds Terminology
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
P Bd2 Bd1
Quantity of Bonds
P B d2 B d1
Quantity of Bonds
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
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.
Expected Inflation
Since Real Interest Rate = Nominal Interest Rate – Expected Inflation, for a given (nominal)
interest rate, then we have
Government Activities
If the government is involved in many activities, it may borrow more for expenditure.
5
Applications
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)
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
Equilibrium condition
BS + MS = Bd +Md
The quantity of bonds and money supplied must equal the quantity of bonds and money
demanded.
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
At this level, we assume that a central bank controls the amount of money supplied, it is
exogenous.
i MS
Quantity of Money
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.
Price-level Effect
Price-level
quantity of money in real terms
Hence, a rise in the price level causes the demand for money
to increase and the demand curve to shift to the right.
Price ↑
Liquidity effect: MS i
MS ↑
Other Effects(MS):
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