Chapter 5 - The Behaviour of Interest Rates

What determines portfolio choice (asset demand)?

Wealth

Expected rate of return

Risk

Liquidity

Cost of acquiring information

Expected inflation

How does wealth affect asset demand?

An increase in wealth generally increases the quantity demanded of most financial assets, holding other factors constant.

What is an expected rate of return?

The return an investor expects to earn on an asset over a future period. It reflects the probability-weighted returns associated with possible outcomes.

How is expected return calculated?

Multiply each possible return by its probability and add the results.

E(R) = SUM of (probability of outcome)(return with the outcome)

What is risk?

The degree of uncertainty surrounding the return on an asset.

what is risk averse?

Prefers lower-risk assets when expected returns are equal.

what is risk loving?

Prefers risky assets because of the possibility of maximizing returns.

what is risk neutral?

Makes decisions based on expected returns, ignoring risk.

how does risk affect asset demand?

Investors demand less of an asset when its risk increases relative to alternative assets, all else equal. Investors generally face a trade-off between risk and return.

what is liquidity, and how does it affect asset demand?

Liquidity is the ease with which an asset can be converted into cash or used to make payments. Greater liquidity makes an asset more desirable and increases its demand relative to other assets.

how do information costs affect asset demand?

Information costs are the costs of obtaining information about an investment. Lower information costs make an asset more attractive and increase demand. investors may accept a lower return on assets that are less costlt to research

how does expected inflation affect asset demand?

Holding other factors constant, higher expected inflation reduces the quantity demanded of an asset in the portfolio-choice framework presented in the slides.

what are the general asset demand relationships?

Holding other factors constant, asset demand is:

- Positively related to wealth.

- Positively related to expected return relative to alternatives.

- Negatively related to relative risk.

- Positively related to relative liquidity.

- Negatively related to information costs.

- Negatively related to expected inflation.

how are bond prices and yields to maturity related?

A bond's price is the present value of its coupon payments and face value. Holding the bond's cash flows constant, its price and yield to maturity move in opposite directions.

bond prices rises = yeild to matriuty falls

bond prices falls = yeild to maturity rises

why can the bond market determine the equilibrium interest rate?

A bond's coupon payments and face value are fixed by its terms. Once its market price is determined, its yield to maturity—and therefore the relevant interest rate—is determined.

what does the bond demand curve represent?

The relationship between the price of bonds and the quantity demanded by investors.

It slopes downward: a lower bond price corresponds to a higher interest rate and a greater quantity of bonds demanded, all else equal.

what does the bond supply curve represent?

The relationship between bond prices and the quantity supplied by existing bondholders and firms considering issuing new bonds.

As presented in the slides, it slopes upward: a lower bond price corresponds to a lower interest rate and a lower quantity of bonds supplied, all else equal.

what is bond market equilibrium?

Equilibrium occurs when the quantity of bonds demanded equals the quantity supplied.

B^d = B^s

This determines the equilibrium bond price, interest rate, and quantity of bonds traded.

whar happens when there is excess demand for bonds?

When B^d > B^s, buyers compete for the available bonds. (Bond prices rise, Interest rates fall) The market moves toward equilibrium.

what happens when there is excess supply of bonds?

when B^d < B^s, the quantity supplied exceeds the quantity demanded. (Bond prices fall, Interest rates rise) The market moves toward equilibrium.

what is the difference between a movement along a curve and a shift of a curve?

Movement along a curve: Caused by a change in the bond's own price; changes quantity demanded or supplied.

Shift of a curve: Caused by a change in another relevant variable; changes demand or supply at every price.

how does wealth affect the demand for bonds?

Wealth increases → bond demand shifts right → equilibrium price rises and quantity rises.

Wealth decreases → bond demand shifts left → equilibrium price falls and quantity falls.

how does expected return affect bond demand?

If the expected return on bonds rises relative to the expected returns on other assets, investors demand more bonds. The demand curve shifts right. If relative expected returns fall, demand shifts left.

how does risk affect bond demand?

If bonds become less risky relative to alternative assets, investors become more willing to hold them, shifting demand right. If their relative risk increases, demand shifts left.

how does liquidity affect bond demand?

Greater bond liquidity increases demand at every price, shifting the demand curve right. Lower liquidity shifts it left.

how do information costs affect bond demand?

Lower costs of acquiring information make bonds more attractive, shifting demand right. Higher information costs reduce demand, shifting it left.

what haooens to the equilibrium bond market when demand increases?

The demand curve shifts right, causing the equilibrium bond price and quantity to rise. Because bond prices and yields move inversely, the equilibrium interest rate falls.

what happens to the equilibrium bond market when demand decreases?

The demand curve shifts left, causing the equilibrium bond price and quantity to fall. The equilibrium interest rate rises.

what factors shift the supply curve for bonds?

Expected pretax profitability of physical capital investments.

Business taxes.

Expected inflation.

Government borrowing.

how does the expected profitability of physical capital investments affect bond supply?

Expected profitability increases → firms become more willing to borrow and issue bonds to finance investment → supply shifts right.

Expected profitability decreases → firms become less willing to issue bonds → supply shifts left.

what happens when bond supply increases?

The supply curve shifts right.

- Equilibrium bond price falls.

- Equilibrium quantity rises.

- Equilibrium interest rate rises

What happens when the bond supply decreases?

The supply curve shifts left.

- Equilibrium bond price rises.

- Equilibrium quantity falls.

- Equilibrium interest rate falls.

how do business taxes affect bond supply?

Business taxes are one of the factors that shift bond supply. Their effect operates through firms' incentives to invest and issue bonds.

how does government borrowing affect bond supply?

An increase in government borrowing increases the supply of bonds, shifting the supply curve right. A decrease in government borrowing reduces bond supply, shifting the curve left.

how can the bond market model explain interest rate changes over business cycle?

Economic expansions and recessions change household wealth and firms' expected profitability. These changes affect bond demand and supply, shifting market equilibrium and changing interest rates.

why do interest rates generally fall during recessions according to the lecture slides?

A downturn reduces household wealth, decreasing bond demand. It also reduces expected profitability, decreasing the supply of bonds. The slides conclude that the new equilibrium has a higher bond price and therefore a lower interest rate.

how does a business cycle expansion affect bond demand and supply?

An expansion generally increases household wealth, raising bond demand, while greater expected profitability encourages firms to issue more bonds, raising bond supply. These changes have opposing effects on bond prices and interest rates, so the net result depends on the relative shifts.

what is the Fisher effect?

The Fisher effect, associated with Irving Fisher, states that the nominal interest rate changes point-for-point with changes in the expected inflation rate, holding other factors constant.

what does the Fisher effect imply?

Higher expected inflation → higher nominal interest rates.

Lower expected inflation → lower nominal interest rates.

Nominal interest rates can change in anticipation of inflation, before actual inflation changes.

how does higher expected inflation affect bond demand?

Higher expected inflation reduces the expected real return on bonds if their nominal payments are fixed. Investors become less willing to hold bonds, shifting the demand curve left.

how does higher expected inflation affect bond supply?

Higher expected inflation increases firms' willingness to issue bonds, shifting the bond supply curve right.

what is the overall effect of increases expected inflation on the bond market?

Bond demand shifts left and bond supply shifts right. Both changes reduce the equilibrium bond price and increase the equilibrium nominal interest rate.

what is the liquidity preference framework?

Developed by John Maynard Keynes, the liquidity preference framework determines the equilibrium interest rate through the supply of and demand for money rather than the supply of and demand for bonds.

how are the bond market and money market frameworks related?

Both frameworks determine the equilibrium interest rate. Although they focus on different markets, they are closely related: equilibrium in the bond market implies equilibrium in the money market under the framework's assumptions.

what are the two ways to hold wealth in the liquidity preference framework?

Money and bonds. The framework assumes these are the two asset categories available for holding wealth.

B^s + M^s = B^d + M^d

Total asset supply equals total asset demand, with B representing bonds and M representing money.

why does equilibrium in the bond market imply equilibrium in the money market?

From the total wealth identity,

B^s - B^d = M^d - M^s

If the bond market is in equilibrium, B^s = B^d. Therefore, M^d = M^s, meaning the money market must also be in equilibrium.

what is a key limitation of th eliquidity preference framework?

By assuming only money and bonds are available assets, it implicitly ignores interest-rate effects arising from changes in the expected returns on real assets, such as houses.

when is each framework more useful?

Portfolio choice / bond market theory (PCT): Easier for analyzing the effects of changes in expected inflation.

Liquidity preference theory (LPT): Simpler for analyzing the effects of changes in income, the price level, and the money supply.

what determines the demand for money?

Interest rate.

Income.

Price level.

how does the interest rate affect the quantity of money demanded?

An increase in the interest rate raises the opportunity cost of holding money and reduces money's relative expected return. Consequently, the quantity of money demanded decreases.

what is the opportunity cost of holding money?

The return an individual gives up by holding money instead of an alternative interest-earning asset. When interest rates rise, this opportunity cost increases, making money less attractive to hold.

how does an increase in income affect money demand?

Higher income increases the demand for money at every interest rate. The money demand curve shifts right.

how does an increase in the price level affect money demand?

A higher price level increases the amount of money needed for transactions. Money demand increases at every interest rate, shifting the demand curve right.

what is the difference between a change in the quantity of money demanded and a change in money demand?

Change in quantity demanded: A change in the interest rate causes movement along the existing demand curve.

Change in money demand: A change in income or the price level shifts the entire demand curve.

who controls the money supply in the liquidity preference framework?

The central bank. The lecture slides assume that the Bank of Canada controls the money supply.

what happens when the bank of canada increases the money supply?

The money supply curve shifts right. In the basic liquidity preference framework, the money supply is perfectly inelastic with respect to the interest rate, so it is represented by a vertical curve.

what determines the equilibrium in the money market?

Equilibrium occurs where the quantity of money supplied equals the quantity of money demanded.

M^s = M^d

The intersection determines the equilibrium interest rate.

what happens when the money supply increases, assuming money demand stays constant?

The supply curve shifts right. At the original interest rate, there is excess money supply. Individuals attempt to exchange money for interest-earning assets, increasing bond prices and lowering interest rates until the money market returns to equilibrium.

what happens when the money demand increases while money supply stays constant?

The money demand curve shifts right, producing excess demand for money at the original interest rate. The equilibrium interest rate rises.

how does an economic expansion affect money demand?

An expansion raises income, increasing money demand and shifting the demand curve right. If money supply remains unchanged, the equilibrium interest rate rises.

what is the liquidity effect?

The liquidity effect is the initial decrease in interest rates resulting from an increase in the money supply, as predicted by the liquidity preference framework.

what is the income effect of an increase in the money supply?

An increase in the money supply can stimulate economic activity, raising national income and wealth. Higher income increases money demand, shifting the demand curve to the right and raising interest rates.

Both the portfolio choice framework and the liquidity preference framework predict this upward pressure on interest rates.

what is the price level effect of an increase in the money supply?

An increase in the money supply can raise the overall price level. A higher price level increases money demand at each interest rate, shifting the demand curve right and raising interest rates according to the liquidity preference framework.

what is the expected inflation effect of an increase in the money supply?

An increase in the money supply may cause people to expect higher future inflation. Higher expected inflation raises nominal interest rates, as predicted by the portfolio choice framework and the Fisher effect.

why can an increase in the money supply cause interest rates to rise?

Although the liquidity effect lowers interest rates, the other three effects can raise them:

- Income effect: Higher income and wealth increase interest rates.

- Price-level effect: A higher price level increases interest rates.

- Expected-inflation effect: Higher expected inflation increases nominal interest rates.

does a higher rate of money supply growth always lower interest rates?

No. The overall effect depends on the relative strength and timing of the four effects. The initial liquidity effect lowers interest rates, but the income, price-level, and expected-inflation effects put upward pressure on them.

how can the effects of increased money supply growth change over time?

The liquidity effect can lower interest rates initially. As income, the price level, and expected inflation respond, the other effects can raise interest rates. Therefore, the short-run and longer-run responses may differ.

what is the relationship between bond prices and interest rates?

inverse:

- bond price increases = interest rate decreases

- bond prices decreases = interest rate increases

what happens when bond demand increases, holding supply constant?

Bond price rises, quantity rises, and the equilibrium interest rate falls.

what happens when bond supply increases, holding demand constant?

Bond price falls, quantity rises, and the equilibrium interest rate rises.

what happens when money demand increases, holding money supply constant?

The money demand curve shifts right and the equilibrium interest rate rises.

what happens when money supply increases, holding money demand constant?

The money supply curve shifts right and the equilibrium interest rate falls in the basic liquidity preference framework. This is the liquidity effect.

how do the two interest rate frameworks differ?

Bond market framework: Interest rates are determined by bond demand and supply.

Liquidity preference framework: Interest rates are determined by money demand and supply.

- Both identify an equilibrium interest rate and are connected through the relationship between money and bonds.

what are the four effects of an increase in money supply growth, and which direction does each push interest rates?

Liquidity effect = down

Income effect = up

Price level effect = up

expected inflation effect = up