Chapter 5

The Behavior of
Interest Rates

Learning Objectives
Identify the factors that affect the demand
for assets.
Draw the demand and supply curves for the
bond market, and identify the equilibrium
interest rate.
List and describe the factors that affect the
equilibrium interest rate in the bond market.

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Determinants of Asset Demand

Wealth: the total resources owned by the
individual, including all assets
Expected Return: the return expected over the
next period on one asset relative to alternative
assets
Risk: the degree of uncertainty associated with the
return on one asset relative to alternative assets
Liquidity: the ease and speed with which an asset
can be turned into cash relative to alternative
assets

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Theory of Portfolio Choice

Holding all other factors constant:
1. The quantity demanded of an asset is positively
related to wealth
2. The quantity demanded of an asset is positively
related to its expected return relative to
alternative assets
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to
alternative assets
4. The quantity demanded of an asset is positively
related to its liquidity relative to alternative assets

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Theory of Portfolio Choice

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Supply and Demand in the Bond

Market
At lower prices (higher interest rates),
ceteris paribus, the quantity demanded of
bonds is higher: an inverse relationship
At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is lower: a positive relationship

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Figure 1 Supply and Demand for

Bonds
Price of Bonds, P ($)
1,000
(i = 0%)
950
(i = 5.3%)

Bs

With excess supply, the

bond price falls to P *
A

900
(i = 11.1%)

P * = 850
(i * = 17.6%)
800
(i = 25.0%)
750
(i = 33.0%)

With excess demand, the

bond price rises to P *

E
Bd

100

200

300

400

Quantity of Bonds, B
($ billions)
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500

Market Equilibrium
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
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Shifts in the Demand for Bonds

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Changes in Equilibrium Interest

Rates
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
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Shifts in the Supply of Bonds

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Shifts in the Supply of Bonds

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
right
Government budget: increased budget deficits
shift the supply curve to the right

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Figure 4 Response to a Change in

Expected Inflation
Price of Bonds, P

B1s
B2s
Step 1. A rise in expected inflation shifts
the bond demand curve leftward . . .
1

Step 2. and shifts the bond supply curve

rightward . . .

P1

Step 3. causing the price of bonds to fall

and the equilibrium interest rate to rise.

2
P2

d
2

B
Quantity of Bonds, B

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B1d

Figure 5 Expected Inflation and Interest Rates

(Three-Month Treasury Bills), 19532014

Sources: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2. Expected inflation calculated using
procedures outlined in Frederic S. Mishkin, The Real Interest Rate: An Empirical Investigation, Carnegie-Rochester Conference
Series on Public Policy 15 (1981): 151200. These procedures involve estimating expected inflation as a function of past interest
rates, inflation, and time trends.

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Figure 6 Response to a Business

Cycle Expansion
Price of Bonds, P

B1s
B2s

Step 1. A business cycle expansion

shifts the bond supply curve
rightward . . .
Step 2. and shifts the bond demand
curve rightward, but by a lesser
amount . . .

1
P1

Step 3. so the price of bonds falls

and the equilibrium interest rate
rises.

P2

d
1

Quantity of Bonds, B

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B2d

Figure 7 Business Cycle and Interest Rates

(Three-Month Treasury Bills), 19512014

Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

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Therefore:
Expected Returns: higher expected interest
rates in the future tends to raise interest rates.
Lower expected interest rates tend to lower
interest rates
Expected Inflation: an increase in the expected
rate of inflation tends to raise interest rates,
while lower expected inflation tends to lower
interest rates
Risk: an increase in the riskiness of bonds
causes interest rates to rise, while a lower risk
of bonds tends to lower interest rates
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Therefore
Liquidity: an increase in liquidity of bonds
usually lowers interest rates, while a
decrease in liquidity tends to raise rates
Government Deficits: Deficits tend to raise
rates while surpluses lower rates
Wealth: during times of economic expansion
rates typical rise, while during recessions
rates tend to fall
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Changes in Money Growth

Increases in Money Growth tends to lower
interest rates
Decreases in money growth tends to raise
interest rates

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Figure 12 Money Growth (M2, Annual Rate) and Interest

Rates (Three-Month Treasury Bills), 19502014

Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

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