Unformatted text preview: BOND MARKET
MECHANICS  I
Interest Rates Moving Together Bond Market Mechanics
Bond
• Outline:
– Interest rates move together
• Event Driven
–
–
–
– Budget deficits
OMO
Economic Growth
Expected Inflation
» Real interest rates and the Fisher Effect – Interest Rate Spread
• Risk
• Time to maturity
• Taxes
Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Bond Market Mechanics
Bond
• Interest rates move together
– Event Driven
•
•
•
• Budget deficits
OMO
Economic Growth
Expected Inflation
– Real Interest Rates and the Fisher Effect Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
Federal Budget Surplus and Deficits () Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
Federal Budget Debt Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
• Bond Market
Bond
Equilibrium
Equilibrium Price
Bsj – At P*
• B d j = B sj
P* Bd j Quantity
Quantity Eco 301  Fall 2011 – Federal Budget Deficits
leads to an increased
supply of bonds,
shifting Bs curve out
(left). Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
• Bond Market
Bond
Equilibrium
Equilibrium Price
Bsj
Bsj(FBD>0)
P*
P**
Bd j Quantity
Quantity Eco 301  Fall 2011 – New Bond Supply curve
lowers bond prices and
increase the interest
rate on that bond.
– Price falls from P* to
P**
– Interest Rate on this
bond will increase!! Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
• Bond J
– The one the Treasury used to finance the deficit • Bond K
– Some other bond
• Corporate,
• Government
• State and Local Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
Price Price Bond J Bond K Bsj Bs K Bsj(FBD>0)
Pj * Pk* Pj** Pk**
Bd j
BD K
BD K (i j ↑) Quantity
Quantity Eco 301  Fall 2011 Quantity
Quantity Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
FBD
• FBD Summary
– Bond J
Bond
• The one the Treasury used to finance the deficit
– Bond Supply increases
– Price bond J falls
– Interest rate on bond j increases – Bond K
• Some other bond
– Bond Demand falls (since the interest rate rises on another
assets – bond j )
– Price bond K falls
– Interest rate on bond K increases – FBD>0 Interest rates of both Bond J and K
FBD>0
increase
increase
Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Open Market Operations (OMO) Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
• Open Market Operations.
– To increase the money supply (lower interest rates)
the Fed buys securities from the public (other things
equal).
• OMO + – To decrease the money supply (increase interest
rates) the Fed sells securities to the public (other
things equal).
• OMO Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
OMO
• Bond Market
Bond
Equilibrium
Equilibrium Price
Bsj – At P*
• B d j = B sj
P* Bd j – Expansionary Open
Expansionary
Market Operations the
FED buys securities
FED
• Bs of that security will fall Quantity
Quantity Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
OMO +
Price Bsj(OMO+)
Bsj • Bond Market
Bond
Equilibrium
Equilibrium
– New Bond Supply curve
increases bond prices
and reduces the
interest rate on that
bond. P**
P* Bd j – Price rise from P* to P** Quantity
Quantity Eco 301  Fall 2011 – Interest Rate on this
bond will fall!! Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
OMO +
• Bond J
Bond
– The one the Fed purchased in the open market
transaction • Bond K
– Some other bond Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Price OMO + Bond J
Bsj(OMO+) Price Bond K Bsj Bsk Pj** PK** Pj * Pk*
Bdk (i j ↓)
Bd j Quantity
Quantity Eco 301  Fall 2011 Bd k Quantity
Quantity Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
OMO +
• OMO(+) Summary
– Bond J
• The one the Fed purchased in the open market transaction
– Bond Supply decreases
– Price Bond J increases
– Interest rate on bond J falls – Bond K
• Some other bond
– Bond demand of bond K increases (since (ij ↓)
– Price of bond K increases
– Interest rate on bond K falls – OMO + Decrease in interest rates on Bond J
OMO
and K.
and
Nick Noble
Eco 301  Fall 2011
Bond Market Mechanics  I Interest rates move together
Interest
Growth
• Bond Market
Bond
Equilibrium
Equilibrium Price
Bsj – At P*
• B d j = B sj
P* • Economic Growth
Bd j – Increase Bus
Opportunities
• Increase Bond Supply – Increase Wealth Quantity
Quantity Eco 301  Fall 2011 • Increase Bond Demand
Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Growth  1
• Bond Supply and
Bond
Demand change equal
amount
amount Price
Bsj Bsj(Bus Opp ↑)
P*
Bdj (Wealth↑ ) – Bond Prices and
interest rates do not
change. Bd j Quantity
Quantity Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Growth  2
• Bond Demand
Bond
changes by more than
bond supply.
bond Price
Bsj P**
P* Bsj(Bus Opp ↑)
Bdj (Wealth↑ ) – Bond Prices rise and
interest rates fall. Bd j Quantity
Quantity Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Growth  3
Price • Bond supply changes
Bond
B
by more than bond
B (Bus Opp ↑) demand.
demand
s
j s
j – Bond Prices fall and
interest rates increase. P*
P**
Bdj (Wealth↑ )
Bd j Quantity
Quantity Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Growth • Bond demand and supply change by the
same amount.
– Interest rates do not change. • Bond supply changes more than bond
demand.
– Bond prices fall and interest rates rise. • Bond demand changes by more than bond
supply.
– Bond prices rise and interest rates fall • Growth Uncertain effect on interest rates.
Growth
Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Expected Inflation – πe
Expected
• Real Interest rate
– Interest rate adjusted for inflation
– Real rate = i  πe
• Backward looking
– June 2008 interest rate on a one year bond was 2.42.
The inflation rate between June 2007 and June 2008
was 1.15, which implies a real interest rate of 3.57
(2.42(1.15))=3.57) • Forward looking
– i – πe i now less inflation expected over next year. The
June 2008 one year bond interest rate was 2.42 and the
U of Michigan expected inflation rate was 3.1 or a real
rate of 0.68. (2.423.10=0.68)
Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Expected Inflation – πe Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Expected Inflation – πe
Expected
Price
Price
Bsj
Bsj(πe ↑) • Bond supply
Bond
increases and bond
demand falls.
demand
– Bond Prices fall and
interest rates increase. P*
P**
Bd j
Bdj (πe ↑ ) Quantity
Quantity Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Expected Inflation – πe
Expected
• Expected Inflation
– Πe ↑ Bond Prices ↓ , i↑ • Fisher Effect
Fisher
– Increases in expected inflation increase
nominal interest rates
– Real rates?
• Πe ↑ , i ↑, then i πe is uncertain. Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Interest rates move together
Interest
Expected Inflation – πe
Expected Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I Bond Market Mechanics
Bond
• Interest rates move together
– Event Driven
• Budget deficits
– FBD>0 i ↑ • OMO
– OMO + i ↓ • Economic Growth
– Growth i ? • Expected Inflation
– Πe ↑ i ↑, but real i ?
Eco 301  Fall 2011 Nick Noble
Bond Market Mechanics  I ...
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This note was uploaded on 10/19/2011 for the course ECON 301 taught by Professor Staff during the Spring '11 term at Miami University.
 Spring '11
 STAFF
 Deficit, Inflation, Interest Rates

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