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