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### Econ+310+Winter+2012+Lecture+12

Course: ECON 310, Spring 2012
School: Michigan
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Word Count: 802

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310 Money Economics and Banking Lecture 12 University of Michigan Winter 2012 Lecture 1 Reading Bond Market and Interest Rates 2 Chapters 5 Date 2011-01-25 2010-07-09 2009-12-23 2009-06-09 2008-11-20 2008-05-07 2007-10-19 2007-04-06 2006-09-20 2006-03-08 2005-08-18 2005-02-03 2004-07-20 2004-01-02 rate (%) Expected Inflation 6 5 4 3 2 1 0 -1 -2 -3 5 yr T-Bond 5 yr TIPS Exp Inf Determining...

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310 Money Economics and Banking Lecture 12 University of Michigan Winter 2012 Lecture 1 Reading Bond Market and Interest Rates 2 Chapters 5 Date 2011-01-25 2010-07-09 2009-12-23 2009-06-09 2008-11-20 2008-05-07 2007-10-19 2007-04-06 2006-09-20 2006-03-08 2005-08-18 2005-02-03 2004-07-20 2004-01-02 rate (%) Expected Inflation 6 5 4 3 2 1 0 -1 -2 -3 5 yr T-Bond 5 yr TIPS Exp Inf Determining Bond Prices and Interest Rates in the Bond Market Negative relationship between bond prices and interest rates If i is high, bond prices must be relatively low If bond prices are high, then i must be low To this point, only the relationship is pinned down (using the present value calculation) i.e. If you know the price, you can deduce the YTM, or if you know YTM you can deduce the price How are bond prices (and interest rates) determined? Must consider equilibrium in the bond market, and the various influences on supply and demand Bond Market Bond Price BondSupply P BondDemand Q Quantityof Bonds Why does the bond demand curve slope downwards? All else held constant, if the current bond price is lower, then Yield to maturity is higher relative to alternative assets; and Short term returns are higher relative to alternative assets Low price will induce a substitution towards bonds i.e. lower prices will increase the quantity of bonds demanded. Demand for Bonds Other Factors Wealth Higher wealth increases demand for all assets Expected real relative returns Expectations of higher bond prices/lower interest rates in the future will increase demand for bonds Expectations of higher returns on equities will reduce demand for bonds Expectations of higher inflation will reduce demand for (nominal) bonds Demand for Bonds Other Factors Relative riskiness of bonds An increase in volatility of the bond market will reduce demand for bonds An increase in volatility of the equity market will increase demand for bonds Relative liquidity An improvement in the ease with which bonds may be traded will increase demand An improvement in the ease with which equities may be traded will reduce bond demand Demand for Bonds - Summary What sorts of things will increase demand for bonds (i.e. shift the bond demand curve to the right)? Increase in wealth Anticipated reduction in interest rates Anticipated reduction in returns on alternative assets Anticipated reduction in inflation Decrease in volatility of the bond market Increase in the volatility of an asset Increased alternative liquidity in the bond market Decreased liquidity in the market for an alternative asset Bond Market Bond Price BondSupply P1 P0 BondDemand Q0 Q1 Quantityof Bonds Supply of Bonds Bonds are a way for corporations, or the federal and local governments, to borrow money and undertake a project Supply of bonds will vary whenever conditions for borrowing vary Why does the supply curve slope upwards? When bond prices are low, then issuer borrows less for the given promised repayments Expected profitability of investment opportunities and bond supply When profitable investment opportunities abound, firms are anxious to borrow money to finance these projects Bond supply increases when profitability of projects improves In particular, we expect the supply of bonds to move pro-cyclically with the business cycle When the economy is in a boom, then profitable investment projects are common In the midst of recession, and therefore in the absence of a multitude of profitable enterprises, we anticipate bond supply to fall Inflationary expectations and the bond supply Bond supply increases with inflation The inflation causes the real cost of borrowing money to fall; So agents look to take advantage of the lower real cost of borrowing by issuing bonds Government budget and the supply of bonds Bond supplies tend to move with the government budget deficit When the federal government runs a budget deficit, they are forced to increase the supply of bonds to finance their overspending. Supply of Bonds - Summary What sorts of things will increase supply of bonds (i.e. shift the bond supply curve to the right)? Increase in the profitability of projects Bond supply tends to move pro-cyclically: a boom in the business cycle is accompanied by a proliferation of worthwhile projects. An increase in expected inflation Federal budget deficit Bond Market Bond Price BondSupply P0 P1 BondDemand Q0 Q1 Quantityof Bonds Example: Impact of increased inflationary expectations Bond Price BondSupply P0 P1 BondDemand Q0 Quantityof Bonds The Fisher Effect If inflationary expectations increase, then Supply of bonds rises The real cost of borrowing falls at any price Demand for bonds falls Real returns are lower at any price Ambiguous effect on volume of trade in the bond market Bond prices unambiguously fall Interest rates rise This is known as the Fisher Effect: higher inflationary expectations leads to an increase in nominal interest rates
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