Ch. 5 (BUS G-345; Money, Banking; and Capital Markets; Self)

Ch. 5 (BUS G-345; Money, Banking; and Capital Markets;...

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Unformatted text preview: Chapter 5: The Behavior of Interest Rates After this chapter you should be able to... LEXplain the relationship of bond prices and nominal interest rates. 2.Model assets in a supply and demand model La using "stocks of assets to determine bond prices and interest rates. 3.Model Ml/M2 in a liquidity preference framework and determine interest rate movements. 4.Understand the similarities and differences in the asset market and liquidity preference approaches to determining interest rate movements. Wm The Supply and Demand for Bonds We will look at assets at a point in time with Quantities in stocks and not flows. First we will consider the demand, then the supply of an asset and finally put the two together to form our model of supply and. demand for bonds Some terms first, 0 {4555, #5 : the total resources owned by the individual, including all assets 0 Expected Return: the return expected over the next period on one asset relative to alternative assets ' fiml : the degree of uncertainty associated with the return on one asset relative to alternative assets 0 Lg?! (“gait : the ease and speed with which an asset can be turned into cash relative to alternative assets Theory of Asset Demand The Demand for bonds shows the relationship between the quantity demanded and the price of bonds when all other economic variables are held constant. For simplicity we can consider our zero coupon bond, then the demand curve must satisfy the below relationship. 2 I i = interest rate = yield to maturity (assuming one period and we hold the bond to maturity) F = Face value of the discount bond P = current price of the discount bond R6 = Expected Return Movements on the demand for bonds, holding all other factors constant is from changes in its . r‘“ , prlcer “96”” \D 621‘ In regards to quahtity demanded the following is true. However, if the only thing that changes first is price then it is a movement on the curve. o The quantity demanded of an asset is gm fla‘vxev’z related to wealth o The quantity demanded of an asset is {came/I related to its expected return relative to alternative assets 0 The quantity demanded of an asset is Mfladvefg’ related to the risk of its returns Mme w to alternative assets 0 The quantity demanded of an asset is 1056514. w: (/3/ related to its liquidity [daem- to alternative assets ‘- Shifts in the Demand for Bond_s__f 4* l.W;alth: in an expansion with growing wealth, the demandcurve for bonds shifts to the right 4~ 2. Er-flmzrcj Returns: higher expected interest rates in the future lower the expected return for long—term bonds, shifting the demand curve to r.— thelifi 'L’J 1’ .' / l": "f — 3. En: _ Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to ._.._ _._.__.- t0 the E ' Efrng =- 4. fl V3 : an increase in the riskiness of bonds causes the demand curve to shift to the BE + 5. - - ~ : increased liquidity of bonds results in the demand curve shiftingght {2.er F9 n. Supply and Demand for Bonds SJEEILIQEJJDDQS is the relationship between the quantity supplied and the price when all other economic variables are held constant. Movements on the supply for bonds occur when there is a change in the current price or interest rates. . _ 5: ; L ("p-{mi a. ;:.' (Sf-{€27 Shifts in the Su 1 of Bonds + 1.Expected profitability of investment“ WWW“... O£pBWI in an expansion, the supply curve shifts to the right +2.Expe§ew an increase in expected inflation shifts the supply curve for bonds to the light t 3W increased budget deficits shift the supply curve to the right filarW Keith/f" .' #:119- £515», 4" 6 Putting the market together for a $1,000 zero coupon bond suppose we have the below market. Price of Bonds, P ($) 1 ,000 (i: 0%) 950 (i: 5.3%) 900 (1":1110/0) P' = 850 (1' = 17.6%) 800 (i: 25.0%) 750 (i : 33.0%) 100 200 300 400 500 Quantity of Bonds, 8 (s billions) Recall for demand we need the following relationship to hold. or G I a“) ‘f‘ r. K, r-.: N - ' ' .I _. " ._ ._ I I I T « . W . t T '. \. / I ’4 r“) " J a ll: ‘ Let’s shock the system by changing some of the shift factors of demand and supply. What happens to interest rates and prices when the following happen? l.Expected Inflation increases? How about A r 9 ,. A! a y I t. Jaw]— f4. decreases. I {(61% aging , Mafia 2.The economy is in an expansion of the business cycng How about a contraction? Does the model’s prediction matc%h the data in the following Wofidiagrabrans? “Wt pm? ' a?) 5’9, mm (L Q17 WEI: 1‘ . If “AC-W046? ;, Dewar} effing: , 50 pn‘f'g. G-fecrnrcrffif)‘ (W14 ’7“) «143,;- ifl r5 nevi-w cr'rmr ljguflfl'db {incur/{:35 " lMC‘fiflCpS P PWr '13 r5 hc/ 05 Diem- Figure 5: Expected Inflation and Interest Rates (3—month T-Bill), 1953-2008 M‘Nfivfl I 2005 Annual Rate (%) 20 16 Expected Inflation 12 1 8 Interest Rate I. 1 AK? rfik—rfl 4 ,1: J x O 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2010 Figure 7: Business Cycle and interest rates (3 month T-Bill) 1951-2008 Interest Rate 1%) 1 8 1 6 1 4 12 10 1 1:21 WW 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 The Liquidity Preference Framework is based on a Keynesian model that determines the _ equilibrium interest rate in terms of supply of and demand for money. There are two main categories of assets that people use to store their wealth: money and bonds. Total wealth is the economy is then given by Bsi/W: Emit” M“! and thus :25“ Be; :MJ_M.5 If the market for money (Ml/M2) is in equilibrium M“ :m “J and thus the bond market is also in equilibrium since this means that I? 1‘- 3L. Fw/ Interest Rate, i M LA, 1' II ‘ K 3 ( Im/c’) (mid é‘lltl'kf'fl agar; fix-55¢ (ea-ant 30 a" v - .. {Legit}- "":I-_ ':. I: {If h 20 O 100 200 300 400 500 600 Quantity of Money, M $ billions ( ) 10 'IA m. Demand for Money in the Liquidity Preference Framework Movements on the demand. for money are caused by changes in the 111th o For example, as the interest rate increases: (.. F" ghit‘ts in the Demand for Money 0' : a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right Z? ° : a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to to the right 9 f a fl " f If . . “ ' r A) \\ l .. x \N r i #2\ m i' , 11 I ’l- a\_, .\.__I\ ’1, r x : (__ i " ,I' /' fli ' _.__ /-/‘ 5 . r___|______ _' __ Why hold money? 0 To perform transactions quickly and easily 0 iquidi demand for money is the demand for money that represents the needs or desires off individuals or firms to make purchases on short notice without incurring excessive c0sts. o Speculation demand for money is the demand for money that reflects holding money over short periods is less risky than holding stocks or bonds. l2 For now assume that the supply of money is completely controlled by the central bank. This translates to a vertical supply curve for money (Ml/M2). What happens to the interest rate when we put this market together and the following occurs? 0 There is a change in the Price Level? 4" p 0 There is a change in the aggregate income? 0 There is a change in the supply of money? I I / ,-__.. . rad. l3 /7' M J mgr/MW! MM: The model depends on everything else remaining equal, such as expected inflation, but does it? 515% 0 Liquidity preference framework leads to the conclusion that an im in the money supply will lower interest rates: the liguidiflt. I ._' 3 m 0 Income “egg; finds interest rates rising because increasing the money supply is an expansionary _W—-—u~——fl—_—_fl influence on the economy (the demand curve shifts to the right). 14 \ \\ \‘Cx‘ex Price-Level Effect and Expected-Inflation Effect 0 A onetime increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices. 0 Price—level effect remains even after prices have stopped rising. o A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stopsrrising, expectations of inflation H_—P--‘——_..__, . Willreturn .to..zero. —~__ o Expected-inflation effect persists only as long as the price level continues to rise. 15 Figure 11: Response over Time to an Increase in the Growth Rate of Money Interest Rate, i (a ) Liquidity effect iarger than ofher effects _ _ Time Liquidity income. Price-Level, Effect and Expected- infiation Effects Interest Rate, i (b) Liquidity effect smaiier than other effects and siow acfiustmenr of expected inflation Time Liquidity income, Price-Level, Effect and Expected- lnflaiion Effects Inierest Rate, i' {c} Liquidity effect smaiier than expected-inflation effect and fast adjustment of expected inflation i.— _—a ‘ . Time Liquidity and Income and Price- Expected- Level Effecis inflation Eiiecis 16 -. Ia‘. xiii LI gawugwop 01 swaas 111M018 Kauoul 013su0dsaJ 1png OLDE 9002 0008 966!- 0661— 9961 OBBI. QLGL OLBL SQSL OQBL QQBL OQBL L0 al— 3 8— 3-- b" 0 ' 1- a E 013‘ E 3193 183131U| \ I 17 p . "k ‘ \ wit a I " p; I 9 El 2‘ II /’ B 8 L’yfiMAf‘l I 0L an it hL 9L (am; 9192:: LgtrmJg) £900qu 22 El 173 UP. 72 -- 93 W 88 98 03 8E: 38 our: =3 was t Inn“: (%J 9193 ,ch ~11~ A .J 13319111! flauogx} 800Z—096I‘(SH!E[ Kmsvau Inflow-mu) sewn 19.191111 pma (emu wilan ‘ZIAD 111M019 Keuow ZI EDIIIDIJ ...
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Ch. 5 (BUS G-345; Money, Banking; and Capital Markets;...

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