Lecture 6: The Behavior of Interest
Rates
Understanding Interest Rates - - Professor G arratt 4-1
Determinants of Asset Demand
• Wealth: the total resources owned by the individual, including
all assets
• Expected Return: the return expected over the next period on
one asset relative to alternative assets
• Risk: the degree of uncertainty associated with the return on one
asset relative to alternative assets
• Liquidity: the ease and speed with which an asset can be turned
into cash relative to alternative assets
Theory of Portfolio Choice
Holding all other factors constant:
1. The quantity demanded of an asset is positively related to wealth
2. The quantity demanded of an asset is positively related to its expected
return relative to alternative assets
3. The quantity demanded of an asset is negatively related to the risk of
its returns relative to alternative assets
4. The quantity demanded of an asset is positively related to its liquidity
relative to alternative assets
Summary Table 1 Response of the Quantity of an
Asset Demanded to Changes in Wealth, Expected
Returns, Risk, and Liquidity
Supply and Demand in the Bond
Market
• At lower prices (higher interest rates), ceteris paribus,
the quantity demanded of bonds is higher: an inverse
relationship
• At lower prices (higher interest rates), ceteris paribus,
the quantity supplied of bonds is lower: a positive
relationship
Derivation of Bond Demand Curve
One-year, discount bond, F = $1000
e (F – P)
i = RET = (= yield to maturity)
P
Point A:
P = $950
($1000 – $950)
i= = 0.053 = 5.3%
$950
d
B = $100 billion
The Behavior of Interest Rates - - Professor G arratt 5-6
Derivation of Bond Demand Curve
Point B:
P = $900
($1000 – $900)
i= = 0.111 = 11.1%
$900
d
B = $200 billion
d
Point C: P = $850, i = 17.6% B = $300 billion
d
Point D: P = $800, i = 25.0% B = $400 billion
d
Point E: P = $750, i = 33.0% B = $500 billion
d
Demand Curve is line B which connects points A, B, C, D, E.
Has usual downward slope.
The Behavior of Interest Rates - - Professor G arratt 5-7
Derivation of Bond Supply Curve
Underlying premise: At higher bond prices (lower cost of borrowing)
firms are willing to supply more bonds.
s
Point F: P = $750, i = 33.0%, B = $100 billion
s
Point G: P = $800, i = 25.0%, B = $200 billion
s
Point C: P = $850, i = 17.6%, B = $300 billion
s
Point H: P = $900, i = 11.1%, B = $400 billion
s
Point I: P = $950, i = 5.3%, B = $500 billion
s
Supply Curve is line B that connects points F, G, C, H, I.
Has the usual upward slope.
The Behavior of Interest Rates - - Professor G arratt 5-8
Figure 1 Supply and Demand for
Bonds
Market Equilibrium
• Occurs when the amount that people are willing to
buy (demand) equals the amount
that people are willing to sell (supply) at a given price
• Bd = Bs defines the equilibrium (or market clearing)
price and interest rate.
• When Bd > Bs , there is excess demand, price will rise
and interest rate will fall
• When Bd < Bs , there is excess supply, price will fall
and interest rate will rise
Changes in Equilibrium Interest
Rates
• Shifts in the demand for bonds:
• Wealth: in an expansion with growing wealth, the demand curve
for bonds shifts to the right
• Expected Returns: higher expected interest rates in the future
lower the expected return for long-term bonds, shifting the
demand curve to the left
• Expected Inflation: an increase in the expected rate of inflations
lowers the expected return for bonds, causing the demand curve
to shift to the left
• Risk: an increase in the riskiness of bonds causes the demand
curve to shift to the left
• Liquidity: increased liquidity of bonds results in the demand
curve shifting right
Figure 2 Shift in the Demand Curve
for Bonds
Summary Table 2 Factors That Shift the
Demand Curve for Bonds
Shifts in the Supply of Bonds
• Expected profitability of investment opportunities: in an
expansion, the supply curve shifts to the right
• Expected inflation: an increase in expected inflation
shifts the supply curve for bonds to the right
• Government budget: increased budget deficits shift the
supply curve to the right
Summary Table 3 Factors That Shift
the Supply of Bonds
Figure 3 Shift in the Supply Curve
for Bonds
Figure 4 Response to a Change in
Expected Inflation
Figure 5 Expected Inflation and Interest Rates
(Three-Month Treasury Bills), 1953–2011
Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An
Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures
involve estimating expected inflation as a function of past interest rates, inflation, and time trends.
Figure 6 Response to a Business
Cycle Expansion
Figure 7 Business Cycle and Interest Rates
(Three-Month Treasury Bills), 1951–2011
Source: Federal Reserve: [Link]/releases/H15/[Link].
Supply and Demand in the Market for Money:
The Liquidity Preference Framework
Keynesian model that determines the equilibrium interest rate
in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs + M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).
Figure 8 Equilibrium in the Market
for Money
Demand for Money in the Liquidity
Preference Framework
• As the interest rate increases:
– The opportunity cost of holding money increases…
– The relative expected return of money decreases…
• …and therefore the quantity demanded of money
decreases.
Changes in Equilibrium Interest Rates in the
Liquidity Preference Framework
• Shifts in the demand for money:
• Income Effect: a higher level of income causes the
demand for money at each interest rate to increase and
the demand curve to shift to the right
• Price-Level Effect: a rise in the price level causes the
demand for money at each interest rate to increase and
the demand curve to shift to the right
Shifts in the Supply of Money
• Assume that the supply of money is controlled by the
central bank
• An increase in the money supply engineered by the
Federal Reserve will shift the supply curve for money
to the right
Summary Table 4 Factors That Shift the
Demand for and Supply of Money
Figure 9 Response to a Change in
Income or the Price Level
Figure 10 Response to a Change in
the Money Supply
Price-Level Effect
and Expected-Inflation Effect
• A one time increase in the money supply will cause prices to rise to a
permanently higher level by the end of the year. The interest rate will rise via
the increased prices.
• Price-level effect remains even after prices have stopped rising.
• A rising price level will raise interest rates because people will expect inflation
to be higher over the course of the year. When the price level stops rising,
expectations of inflation will return to zero.
• Expected-inflation effect persists only as long as the price level continues to
rise.
Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?
• Liquidity preference framework leads to the conclusion
that an increase in the money supply will lower interest
rates: the liquidity effect.
• Income effect finds interest rates rising because
increasing the money supply is an expansionary
influence on the economy (the demand curve shifts to
the right).
Does a Higher Rate of Growth of the Money Supply
Lower Interest Rates? (cont’d)
• Price-Level effect predicts an increase in the money
supply leads to a rise in interest rates in response to the
rise in the price level (the demand curve shifts to the
right).
• Expected-Inflation effect shows an increase in interest
rates because an increase in the money supply may lead
people to expect a higher price level in the future (the
demand curve shifts to the right).
Figure 11 Response
over Time to an
Increase in Money
Supply Growth
Figure 12 Money Growth (M2, Annual Rate) and
Interest Rates (Three-Month Treasury Bills),
1950–2011
Sources: Federal Reserve: [Link]/releases/h6/hist/[Link].
