Summary of Chapter 4: The Behavior of Interest Rates

The Economics of Money, Banking, and Financial Markets

## Chapter 4: The Behavior of Interest Rates

Learning Objectives

  • 5.1 Understand the concepts of interest rates and rates of return; nominal and real.

  • 5.2 Identify the factors that affect the demand for assets.

  • 5.3 Draw the demand and supply curves for the bond market and identify the equilibrium interest rate.

  • 5.4 List and describe the factors that affect the equilibrium interest rate in the bond market.

  • 5.5 Describe the connection between the bond market and the money market through the liquidity preference framework.

  • 5.6 List and describe the factors that affect the money market and the equilibrium interest rate.

Interest Rates – Contexts & Perspectives
Contexts

  • Return on Financial Assets:

    • Involves the rate of return, yield to maturity (YTM), real interest rate vs. nominal interest rate.

  • Cost of Borrowing:

    • Includes bank lending rates and interbank rates.

  • Policy Rates of Monetary Policy:

    • Relevant when determining the money supply.

  • Overall Interest Rate in Economy:

    • Reflects the aggregated economic environment.

Perspectives

  • Lenders:

    • See interest as the return on investment.

  • Borrowers:

    • View interest as the cost of borrowing.

  • Investors:

    • Consider the associated interest rate risk.

Yield to Maturity (YTM)

  • Yield to Maturity Defined:

    • The interest rate that equates the present value of cash flow payments from a debt instrument with its current value.

  • Present Value Concept:

    • A dollar paid one year from now is worth less than a dollar paid today, emphasizing the time value of money.

  • Importance of YTM:

    • YTM provides a precise measure of the present value of interest rates on any debt instruments.

Types of Credit Market Instruments

  1. Simple Loan

    • Borrower repays a single principal plus interest.

  2. Fixed Payment Loan

    • Consistent cash flow payments throughout the loan's life.

    • Formula:

      LV = \frac{FP}{(1+i)} + \frac{FP}{(1+i)^2} + \dots + \frac{FP}{(1+i)^n}

  3. Coupon Bond

    • Pays a periodic coupon until maturity, at which point the face value is returned.

    • Formula:

      P = \frac{C}{(1+i)} + \frac{C}{(1+i)^2} + \ldots + \frac{C}{(1+i)^n} + \frac{F}{(1+i)^n}

    • At face value, YTM equals the coupon rate, and the price and YTM relationship is inversely correlated.

  4. Discount Bond

    • Sold below par value.

    • Formula:

i = \frac{F - P}{P}

Distinction Between Interest Rates and Returns
Rate of Return (ROR)

  • Definition:

    • The payments to the owner plus changes in value expressed as a fraction of the purchase price.

  • Formula:

    RET = \frac{P{t+1} - Pt + C}{P_t}

  • Components:

    • Current yield:

    i = \frac{C}{P_t}

    • Rate of capital gain:

    g = \frac{P{t+1} - Pt}{P_t}

Interest Rate Movements & Effects

  • Yield to maturity (YTM) as a return equals only if the holding period equals the bond's maturity.

  • Relationship between bond prices and interest rates:

    • Interest rates rise → Bond prices fall (capital loss if maturity exceeds holding period).

    • Further, distant maturities exhibit greater percentage price change sensitivity to interest rate changes.

Nominal vs Real Interest Rates

  • Nominal Interest Rate:

    • Ignored inflation effects; reflects future rate obligations.

    • Example: A nominal rate of 10% means RM10 borrowed today will be RM11 next year.

  • Real Interest Rate:

    • Adjusted for inflation, depicts true borrowing costs.

    • Formula:

Real = Nominal - Expected \text{ inflation}

Determinants of Asset Demand

  • Economic agents possess various assets of value, inclusive of money, bonds, stocks, real estate, etc.

  • Primary Determinants:

    1. Wealth:

    • Total resources owned by individuals.

    1. Expected Return:

    • Anticipated return on an asset versus alternatives.

    1. Risk:

    • Degree of uncertainty regarding the returns associated with the asset.

    1. Liquidity:

    • Ease/speed of converting an asset into cash compared to alternatives.

Effects on the Quantity Demanded

  1. Wealth ↑ → Quantity Demanded ↑

  2. Expected Return ↑ → Quantity Demanded ↑

  3. Risk ↑ → Quantity Demanded ↓

  4. Liquidity ↑ → Quantity Demanded ↑

Theories on the Determination of Interest Rates
1. Classical Model (Bond Market)

  • Loanable Funds:

    • Interest rates arise from supply and demand for loanable funds, inversely tied to bond supply and demand.

    • Lenders (bond buyers) are also suppliers of loanable funds as they seek returns.

2. Keynesian Model (Money Market)

  • Equilibrium interest rate reflects supply/demand for money.

  • Total wealth distribution captures balance between money and bonds.

  • Equilibrium in Money Market:

    • Aligning money demand to bond demand, maintained by central bank control of money supply.

Equilibrium Interest Rates in the Liquidity Preference Framework

  • Shifts in Demand for Money:

    • Income Effect: Higher income increases money demand, shifting the curve right.

    • Price-Level Effect: Rising prices augment nominal money holdings needed, shifting demand right.

  • Shifts in Supply of Money:

    • Central banks adjust the money supply affecting availability and influencing interest rates accordingly.

Business Cycle Effects on Interest Rates
Expansion Phase:

  • Increased output leads to higher borrowing; simplistic logic shifts demand and supply curves for bonds accordingly.

  • Interest rates rise as prices fall, inversely correlated with bond price shifts.

Contraction Phase:

  • Reduced economic activity leads to lower demand for bonds; while increased bond prices occur, causing a decrease in interest rates.

Sources and References:

  • Federal Reserve Bank of St. Louis FRED database.