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Chapter 6
Determining
Market
Interest Rates
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Views of Bond Market
We can view the buyer of bonds and the seller of
bonds in 2 ways:
1) The bond is the good: the lender is buying the
bond and the borrower is selling the bond. Price
= amount lender pays
2) Use of funds is the good: the borrower is
buying the use of funds and pays with a promise
to repay. Price = interest rate
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Bond is the Good
Lender buys the bond
Borrower raising
funds
Borrower selling
bond
Lender supplying
funds
Bond price
Interest rate
Buyer
Seller
Use of Funds is the
Good
Price
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Figure 6.1 Demand for Bonds
by Lenders
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Figure 6.2 Supply of Bonds by
Borrowers
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Figure 6.3 Equilibrium in Markets for
Bonds and Loanable Funds
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Explaining Changes
in Equilibrium Interest Rates
• Changes in bond demand or supply will change
the bond price and interest rate.
• Theory of portfolio allocation can explain bond
demand curve shifts.
• Changes in willingness and ability to borrow
shifts the supply curve.
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Figure 6.4 Shifts in the
Demand for Bonds
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Factors Shifting Increasing
Bond Demand
•
•
•
•
•
•
•
Higher wealth
Higher expected returns on bonds
Lower expected inflation
Lower expected return on other assets
Lower relative riskiness of bonds
Higher relative liquidity of bonds
Lower relative information costs of bonds
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Factors Increasing Bond
Supply
•
•
•
•
Higher expected profitability of capital
Lower business taxes
Lower expected inflation
Higher government borrowing
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Figure 6.5 Shifts in the Supply
of Bonds
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Figure 6.6 Interest Rate Changes
in an Economic Downturn
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Figure 6.7 Expected Inflation
and Interest Rates
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The International Capital Market
and the Interest Rate
• Closed Economy: an economy that neither borrows
nor lends to foreign countries
• Open Economy: capital is mobile internationally
• World real interest rate (rw): the interest rate that is
determined in the international capital market
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Figure 6.8 Flow of Funds in an
Open Economy
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Open Economies
• Small open economy: the quantity of loanable
funds supplied is too small to affect the world
interest rate and the economy takes rw as given
• Large open economy: an economy that is large
enough to affect the world interest rate
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Figure 6.9 Determining the Real
Interest Rate in a Small Open Economy
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Figure 6.10 Determining the Real
Interest Rate in a Large Open Economy
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Table 6.1 Factors That Shift
the Demand Curve for Bonds
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Table 6.2 Factors That Shift
the Supply Curve for Bonds
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