Download The Behavior of Interest Rates

The determination of bond prices and
interest rates
Mishkin, Chap 5
1
Chap 5 discusses:
I.
The classical theory of bond prices and interest
rates
II. The liquidity preference theory (Keynesian
theory) of bond prices and interest rates
III. Critique of the liquidity preference theory Money supply and the market interest rates
2
Difference between a market for loans and a bond market – a recap
•In a market for loans, the interest rate on a loan is determined by market forces
of demand and supply.
Given a LV and n, the FP is then determined from the PV relationship.
Equivalently, given FP and n, the LV is then determined from the PV
relationship.
•In a market for bonds, the bond price is determined by market forces or demand
and supply.
Given C, FV and n, the interest rate or yield to maturity is then determined from
the PV relationship.
Thus the difference lies in which is regarded as the market determined variable –
price or interest rate.
3
I.
The classical theory of bond prices and interest rates
Demand for a bond (generally for any asset) depends on:
•
average time preference of households; the more willing the households are
to defer their current consumption, the _________ the demand.
•
average wealth level of households ; the higher the wealth level, the
_______ the demand
•
expected return on the bond over the holding period; the greater the
expected return the ________ the demand
•
the risk on the bond; assuming agents to be risk averse, the greater the risk,
the ________ the demand. Risk is often measured by _______
•
the liquidity of the bond; the greater the liquidity the _______ the demand.
Liquidity is often measured by ________
4
Demand for bonds
Given wealth, savings propensities, risk and liquidity, quantity demanded of bond
is _________ related to the expected return on it.
If so, how is the quantity demanded related to the current market price of the
bond? Hint: Back to chap 4
for short term investors: one period RET = (C + Pt+1 – Pt)/Pt
for someone who holds till maturity: RET = YTM based on the current market
price
How is RET related to Pt in both cases?
Hence quantity demanded is _______ related to current market price. The
demand curve for bonds shows
5
Supply of bonds
From the issuer’s (borrower’s) point of view, what is the cost of borrowing?
Hence, quantity supplied of bonds is _______ related to its current market price
everything else constant. The supply curve of a bond shows
Equilibrium in the bond market:
the price at which quantity demanded ________ quantity supplied.
If bond price > market clearing price
If bond price < market clearing price
Equilibrium price implies a corresponding equilibrium interest rate. Why?
6
price of the bond
1.
Draw the
demand and
supply of the
bond. Indicate
the sources of
each (who
demands or
supplies?)
2.
Add a third
interest rate axis
to alternatively
express these
relationships.
quantity of the bond
7
The market for loanable funds is another name for the market for bonds.
Demand for bonds = __________ loanable funds;
Supply of bonds = __________ loanable funds;
Interest rate
Draw the supply of and demand
for loanable funds and also mark
them with their alternative labels.
Quantity of bonds
8
Factors affecting demand, supply and the equilibrium interest rate
1.
increase in the average wealth level?
Price of the bond
S0
D0
Quantity of the bond
2. increase in expected (future) interest rate?
Price of the bond
S0
Hint: What happens to the
future price of the bond?
What happens to the one
period rate of return?
D0
Quantity of the bond
9
3. increase in the expected return on an alternative asset such as a stock or another
bond?
Price of the bond
S0
D0
Quantity of the bond
4. increase in the riskiness of the bond; effect on an alternative asset
P
S0
D0
Q
10
5. increase in the liquidity of the bond? effect on an alternative asset
P
S
0
D0
Q
6. Increase in the expected (future) inflation rate, assuming this is a nominal bond?
P
What happens to the equilibrium
nominal interest rate?
S0
D0
Q
11
7.
increase in business profitability?
P
S
0
D0
Q
8. increase in the government budget deficit?
P
S0
D0
Q
12
Changes in e: the Fisher Effect
Price of a bond
S0
What happens to demand and
supply as πe increases?
Are the shifts equal?
What happens to equilibrium
price?
Equilibrium quantity?
Equilibrium nominal interest
rate?
D0
Quantity of bond
13
Effects of Business cycles - expansion
Price of a bond
S0
What happens to demand and
supply during expansions?
Are the shifts equal?
What happens to equilibrium
price?
Equilibrium quantity?
Equilibrium interest rate?
D0
Quantity of bond
14
II. Liquidity preference or Keynesian theory of the interest rate
Assume only 2 types of assets, bonds and money
Bs + Ms = Bd + Md = total wealth of individuals
or Bs – Bd = Md – Ms
If the money market is ___________, the bond market is ____________also.
Excess ________ in the bond market implies excess _______ in the money market
and the reverse.
The bond market can be analyzed by analyzing the money market. (Note: method
doesn’t work if there are more than 2 assets)
Demand for money: money is demanded
i)
because of its
this component depends on
i)
because it can act as a
this component
15
Supply of money: assumed constant for the present
Money market equilibrium: assuming _______ price level and income level,
the __________ at which Md = Ms
Interest rate
The demand for and supply of
money and show the
equilibrium interest rate.
Quantity of money
16
Factors that affect demand, supply and the equilibrium interest rate, according
to the liquidity preference theory:
1. an increase in income?
3. An increase in money supply?
Interest rate
i
Quantity of money
2. an increase in the price level?
i
M
(3) is called the liquidity
effect of an increase in money
supply.
M
17
III. Critique of LP theory
Major difference between the classical and the Keynesian (LP) theory:
The Keynesian theory ignores some other effects of an increase in money supply
on the interest rate. These are
-
-
-
Of the above three, the classical theory of interest emphasizes _____ as the most
important quantitatively in the long run.
18