finance HW
muteb11
week-4_interest_rates_new.pptxWeek- 4 Interest Rates and Interest Rate Behavior
Money and Banking Econ 311
Thursday 7 - 9:45
Instructor: Thomas L. Thomas
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
2
Theory of Portfolio Choice
Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
3
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
4
Supply and Demand for Bonds
5
Factors That Shift the Demand Curve for Bonds
6
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
7
Factors That Shift the Supply of Bonds
8
Response to a Change in Expected Inflation
9
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.
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Response to a Business Cycle Expansion
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Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2011
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
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Supply and Demand in the Market for Money: The Liquidity Preference Framework
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Equilibrium in the Market for Money
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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
16
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
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Factors That Shift the Demand for and Supply of Money
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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.
19
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).
20
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).
Response over Time to an Increase in Money Supply Growth
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Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2011
Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
What happed here?
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Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due to:
Default risk
Liquidity
Tax considerations
Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
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Risk Structure of Interest Rates (cont’d)
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government can raise taxes).
Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
26
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
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Risk Structure of Interest Rates (cont’d)
Liquidity: the relative ease with which an asset can be converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal income taxes.
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
30
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first two
Liquidity premium theory combines the two theories to explain all three facts
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Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be perfect substitutes
32
Expectations Theory: Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next year.
Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
33
Expectations Theory (cont’d)
Explains why the term structure of interest rates changes at different times
Explains why interest rates on bonds with different maturities move together over time (fact 1)
Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2)
Cannot explain why yield curves usually slope upward (fact 3)
34
Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
35
Liquidity Premium & Preferred Habitat Theories
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
Bonds of different maturities are partial (not perfect) substitutes
36
Liquidity Premium Theory
37
Preferred Habitat Theory
Investors have a preference for bonds of one maturity over another
They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return
Investors are likely to prefer short-term bonds over longer-term bonds
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The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory
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Keynesian model that determines the equi
librium 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 bo
ssdd
sdsd
sd
sd
nds.
Total wealth in the economy = B M = B+ M
Rearranging: B- B = M - M
If the market for money is in equilibriu
m (M = M),
then the bond market is also in equilibr
ium (B = B).
+
int = it + it+1
e + it+2 e + ...+ it+( n−1)
e
n + lnt
where lnt is the liquidity premium for the n-period bond at time t lnt is always positive
Rises with the term to maturity
i
nt
=
i
t
+i
t+1
e
+i
t+2
e
+...+i
t+(n-1)
e
n
+l
nt
where l
nt
is the liquidity premium for the n-period bond at time t
l
nt
is always positive
Rises with the term to maturity
