Download The Behavior of Interest Rates

The Behavior of Interest Rates
The Bond Market Model
Understanding Interest Rates
• Economists use three different models to
explain how interest rates are determined.
– The bond market model
– The money demand/money supply model
– The loanable funds model
The Bond Market Model
• The bond market model is useful because of
the issues that can be considered within its
framework.
– The impact of changes in---•
•
•
•
•
Wealth
Expected interest rates or expected return
Expected inflation
Riskiness of bonds relative to other assets
Liquidity of bonds relative to other assets
The Bond Market Model
• The bond market can be modeled using the
concepts of demand and supply.
– The demand for bonds is determined by
individuals and institutions who wish to hold
their wealth in bonds.
– The supply of bonds is provided by institutions
that issue bonds to raise funds.
The Demand for Bonds
• The demand for bonds comes from savers,
people who have funds in excess of their
spending needs.
• They are willing to hold bonds for two
reasons:
– Interest earned
– Potential capital gains
Bond Demand
• Rate of return
– According to the asset theory of demand,
people compare one asset relative to another
and choose the one that best suits their needs.
• As the opportunity cost of an asset increases, people
find it increasingly unattractive.
Opportunity Cost
• The opportunity cost of an asset is defined
as the difference between the rate of return
received by the asset and the rate of return
on an alternative asset.
– When bond yields are high, people prefer bonds
because the opportunity cost of holding other
assets is high.
– When bond yields are low, people prefer other
assets because the opportunity cost of holding
bonds is high.
Bond Demand
• Investors who demand bonds based on
opportunity cost considerations prefer to
buy when interest rates are high and sell
when interest rates are low.
Bond Demand
• Speculation
– When choosing an asset, investors also consider
risk.
• Interest rate risk occurs when the market value of a
bond falls because interest rates rise.
– As we have seen, the existence of interest rate
risk means investors face the possibility of
capital losses when interest rates rise and
capital gains when interest rates fall.
Speculation
• Investors who speculate in the bond market
prefer to buy when interest rates are high
and sell when interest rates are low.
– When interest rates are high, people expect
them to fall. As they fall, bond prices rise,
yielding a capital gain.
– When interest rates are low, people expect them
to rise. As they rise, bond prices fall,
diminishing capital gains or yielding a capital
loss.
Bond Demand
• Both the opportunity cost motive and the
speculative motive result in investors
demanding bonds when interest rates are
high and selling bonds when interest rates
are low.
The Demand Curve for Bonds
• Let r = RET = (F - P)/P
– If F = $1,000 and P = $950, r = 5.26%
– If F = $1,000 and P = $900, r = 11.1%
• High bond prices are associated with low
interest rates.
• Low bond prices are associated with high
interest rates.
The Demand Curve for Bonds
Bond
Price
0
Interest
Rate
PBhigh
PBlow
Demand
0 QD
low QDhigh
ilow
When bond prices are high,
interest rates are low, and
bond demand is low.
ihigh
When bond prices are low,
interest rates are high, and
bond demand is high.
Bond Supply
• The supply of bonds comes from
institutions, governments (domestic and
foreign), and businesses.
• The quantity of bonds supplied depends in
part on the interest rate bond suppliers must
pay to attract funds.
– As interest rates increase, the quantity supplied
falls.
– As interest rates decrease, the quantity supplied
rises.
The Supply Curve for Bonds
0
Supply Interest
Rate
Bond
Price
PBhigh
ilow
PBlow
0
ihigh
QSlow
QShigh
As bond prices rise, bond yields
fall, and quantity supplied rises.
As bond prices fall, bond yields
rise, and quantity supplied falls.
Equilibrium
• Equilibrium is a state of rest. Either there
are no forces causing change or there are
equal opposing forces.
• In the bond market, equilibrium occurs
when the quantity of bonds demanded just
equals the quantity of bonds supplied.
Equilibrium & Disequilibrium
Bond
Price
0
Interest
S Rate
PBhigh
ilow
Excess supply occurs when
bond prices are high and interest
rates are low.
Eq
PB
eq
ieq
PBlow
ihigh
D
0
100
300
500
Excess demand occurs when
bond prices are low and interest
rates are high.
Disequilibrium
• Excess Supply
– More people want to sell bonds than want to
buy them.
• Bond prices fall and interest rates rise.
• Excess Demand
– More people want to buy bonds than want to
sell them.
• Bond prices rise and interest rates fall.
Shifts in the Demand for Bonds
• According to the asset theory of demand,
changes in bond demand are caused by
changes in--– Wealth
– Expected return on bonds relative to expected
returns on other assets
– Expected riskiness of bonds relative to other
assets
– Liquidity of bonds relative to other assets.
Mechanics of an Increase in
Demand
0
Interest
S Rate
Bond
Price
b
P2
i1
a
P1
i2
D2
D1
0
Q1 Q2
Increases in bond demand cause
bond prices to rise and bond
yields to fall.
Mechanics of a Decrease in
Demand
0
Interest
S Rate
Bond
Price
P1
P2
a
i2
b
i1
D1
D2
0
Q2
Q1
Decreases in bond demand cause
bond prices to fall and bond
yields to rise.
Bond Demand and Wealth
• In a business cycle expansion as wealth
grows, the demand for bonds tends to rise
and the demand curve shifts to the right.
• In a business cycle contraction as wealth
shrinks, the demand for bonds tends to fall
and the demand curve shifts to the left.
Bond Demand and Expected
Returns: Bonds
• Higher expected interest rates in the future
decrease the demand for long-term bonds
and shift the demand curve to the left.
• Lower expected interest rates in the future
increase the demand for long-term bonds
and shift the demand curve to the right.
Bond Demand and Expected
Returns: Other Assets
• Higher expected returns on other assets
relative to bonds cause bonds to become
less attractive and the bond demand curve
shifts left.
• Lower expected returns on other assets
relative to bonds cause bonds to become
more attractive and the bond demand curve
shifts right.
Bond Demand and Expected
Returns: Inflation
• An increase in the expected rate of inflation
will cause the demand for bonds to decline
and the demand curve to shift to the left.
• A decrease in the expected rate of inflation
will cause the demand for bonds to increase
and the demand curve to shift to the right.
Bond Demand and Risk
• An increase in the riskiness of bonds causes
the demand for bonds to fall and the
demand curve to shift to the left.
• An increase in the riskiness of other assets
causes the demand for bonds to rise and the
demand curve to shift to the right.
Bond Demand and Liquidity
• Increased liquidity of bonds results in an
increased demand for bonds and the
demand curve shifts right.
• Increased liquidity of other assets results in
a decreased demand for bonds and the
demand curve shifts left.
Shifts in Supply
• Shifts in the supply curve for bonds are
caused by changes in….
– The expected profitability of investment
opportunities
– Expected inflation
– Government activities
Mechanics of an Increase in
Supply
Bond
Price
0
Interest
Rate
S1
S2
a
P1
P2
i2
b
i1
D
0
Q1 Q2
An increase in the supply of bonds
causes bond prices to fall and bond
yields to rise.
Mechanics of an Decrease in
Supply
0
Interest
S2
Rate
Bond
Price
S1
P2
P1
b
i1
a
i2
D
0
Q2 Q1
A decrease in the supply of bonds
causes bond prices to rise and bond
yields to fall.
Shifts in the Supply of Bonds
• Expected Profitability of Investment
Opportunities
– When an economy is growing rapidly, there are
many profitable investment opportunities. The
supply of bonds increases and the supply curve
shifts to the right.
– When an economy is contracting, there are
fewer profitable opportunities. The supply of
bonds decreases and the supply curve shifts left.
Shifts in the Supply of Bonds
• Expected Inflation
– An increase in expected inflation causes the
supply of bonds to increase and the supply
curve to shift right.
• Inflation causes the real cost of borrowing to fall.
Shifts in the Supply of Bonds
• Government Activities
– Higher government deficits increase the supply
of bonds, causing the supply curve to shift
right.
– Reductions in government deficits decrease the
supply of bonds, causing the supply curve to
shift left.
The Fisher Effect
• When expected inflation increases:
– Bond supply increases and the supply curve
shifts right.
– Bond demand decreases and the demand curve
shifts left.
• As a result, bond prices fall and interest rates rise.
– When expected inflation rises, interest rates
rise. This is the Fisher Effect.
The Fisher Effect
0
Bond
Price
Interest
Rate
S1
Your turn
P1
a
i2
D1
0
Q1
Business Cycle Expansion
• In an economic expansion, GDP and
national income rise.
– Businesses are more willing to borrow, causing
bond
to increase.
– In an expansion, wealth increases, causing bond
–
to increase.
– As a result, bond prices
and interest
rates
.
Business Cycle Expansion
0
Bond
Price
S1
Interest
Rate
Your turn
P1
a
i2
D1
0
Q1