CHAPTER 5 - THE BEHAVIOR OF INTEREST RATES

Nominal interest rates for 3 month Tbills were 1% in the early 50s, reached 15% in 1981, fell to 3% in 1993 and rose to 5% in 1995, and are now about 6% (See page 88). What explains these interest rate movements? Since nominal interest rate movements are negatively related to bond prices, understanding interest rate changes also helps us understand movements in bond prices.  We can either look at the Supply and Demand for Credit to understand interest rate changes or the Supply and Demand for Bonds to understand bond price changes.  We can also look at the Supply and Demand for Money to understand interest rates.  That is, we look at economic conditions and market forces (S and D) in the credit market, bond market, money market to get an understanding of the behavior of interest rates over time.

We start by looking at the Theory of Asset Demand, since bonds and money are assets, and understanding what affects bond demand and money demand allows us to understand market equilibrium and changes in equilibrium interest rates.  Micro (Price Theory) vs. Macro (Interest Rate Theory).  We assume in this chapter that there is a single interest rate in the economy to simplify the analysis, in CH 6 we investigate why interest rates vary for different securities.

Theory of Asset Demand addresses the issue of which assets to buy and which assets to combine in a portfolio.  Example: assume that you just won the lottery or got a large inheritance.  How you decide to invest is the Theory of Asset Demand or the Theory of Portfolio Choice.  And since money is a financial asset (M2), we need to  study money in the context of assets and financial markets.  An asset is any property or security that is used as a store of value, allowing us to transfer our current wealth into purchasing power in the future.

What determines Asset Demand?  Four factors:

1. Wealth.  An increase in wealth raises the demand for an asset, ceteris paribus.

Responsiveness of demand to changes in wealth.

Two types of assets:
i. Normal assets - necessities (elasticity is between 0 and 1) Currency and checking accounts.
ii. Luxury assets - elasticity greater than one. Stocks and bonds

Example: you are very wealthy to start with and your wealth goes up by 10%, you increase your holdings of stocks and municipal bonds by 20% and increase your holdings of cash and checking accounts by less than 10%.

2. Expected returns - an increase (decrease) in an asset's expected return, relative to alternative assets, increases (decreases) the demand for the asset, ceteris paribus.  Example: A company's earnings forecast improves (declines), demand for the stock will increase (decrease), resulting in a higher (lower) price.

3. Risk - if an asset's risk increases (decreases), relative to other assets, the demand will fall (rise).  Assumes investors are risk-averse.   Example: a company's credit rating is downgraded (from AAA to C), demand for its bonds will fall, price will fall.

4. Liquidity - the more liquid an asset is, relative to other assets, the greater the demand, ceteris paribus.  Example:  Treasury securities are the most liquid asset, demand is high, prices are high, interest rates are low.

As investors, we like wealth, expected returns and liquidity, and we don't like risk.   See page 95, Table 1.

LOANABLE FUNDS FRAMEWORK: S AND D IN THE BOND MKT

S and D in the credit markets. We simplify in this chapter and assume there is only ONE int rate in the economy for a single type of bond. We use the Theory of Asset Demand and look at the bond market.

Demand Curve for Bonds (Bond demanders are bond investors/buyers/savers/lenders and Bond suppliers are bond issuers/sellers/borrowers: corporations and municipalities), see page 97.

Assume one year, discount bonds with face value of \$1000.

I = YTM = (1000 - Price) / Price

If bond sells for \$950 and FV = \$1000, then the YTM = \$50 / 950 = 5.3% and the Bd is \$100B (Point A).

If bond sells for \$900, the i = 11.1% and  Bd= \$200B (Point B)

If bond sells for \$800, the i = 25%. and Bd = \$400B (Point D)

At lower prices and higher interest rates, the Bd will be higher. Investors like: low bond prices and high interest rates.

SUPPLY CURVE FOR BONDS - FIRMS AND LOCAL GOVERNMENTS

The higher the price and the lower the interest rate, the more bonds will be supplied by firms, and therefore the supply curve slopes upward. At a price of \$750 and an int rate of 33%, bond suppliers will only want to provide \$100B (Point F). At a price of \$950 and interest rate of 5.3%, they will supply \$500B (Point I).

Companies/borrowers like: high bond prices and low interest rates.

MARKET EQUILIBRIUM- Market clearing. Qd = Qs, Bd = Bs.  Given the market forces described for Bond S and D, the market clearing price is \$850 and the market equilibrium interest rate is 17.6%.

Suppose that the price was NOT \$850, but was \$950. Firms would want to supply \$500B (Point I) and investors would only want to buy \$100B (Point A).
Qs > Qd or Bs > Bd.  There were be an excess supply or a surplus of bonds, which would put downward pressure on the price of bonds.  As the price is lowered, more investors will want to buy bonds. Market forces will push the price down to \$850.

If the price was only \$750, there would be excess demand (Point E vs. Point F), or a bond shortage.  Qd >Qs or Bd > Bs.  Prices would get bid up to \$850.  Market forces would drive the P to \$850 and Int to 17.6%.

LOANABLE FUNDS MARKET - We can also analyze S and D in the credit markets using the Loanable Funds Framework, where we put interest rates on the vertical axis, instead of price.  We then look at the S and D for CREDIT (not bonds).

Demand for credit (Dc), or the Demand for loanable funds, is the Demand for Borrowing, so it would be the firms that supply bonds that are demanding credit, the Borrowers.  Dc slopes downward because:

Supply of credit (Sc), Supply of Loanable funds, are the Bond Investors/buyers, Savers, the Suppliers of credit.  Supply of Credit slopes upward because:

Note: When analyzing changes in interest rates, we can use either framework and get the SAME RESULT.

CHANGES IN EQUILIBRIUM INTEREST RATES

We will now look at why and how interest rates changes. Like in micro, we make a distinction between 1) a change in Qd or a change in Qs (movement along a demand curve or supply curve) and 2) change in Demand or change in Supply - shift in the entire curve.

A. SHIFTS IN BOND DEMAND by Investors using the Theory of Asset Demand, four factors: Wealth, Expected return on bonds relative to other assets, Riskiness of bonds relative to other assets, and Liquidity of bonds relative to other assets.

1.Wealth - If wealth goes up, for an individual or the country, the demand for bonds will rise, Bd shifts to the right. In an economic expansion, Demand for Bonds (Bd) goes up, bond prices ________, interest rates ___________.  Or, the Supply of Credit (savings) goes _________, interest rates fall in Loanable Funds framework.

If wealth goes down e.g. during a recession, we have the opposite effects: Demand for bonds (Bd) falls, prices _________, int rates go _________.

2.Expected returns - If interest rates are expected to increase in the future, the Demand for Bonds (Bd) NOW will decline,  Bd will shift to the left, bond prices will ____________ .  Two reasons why higher expected returns decrease Bd now :

a)

b)

If rates are expected to fall, people will buy more bonds now, Bwill increase, demand curve will shift up and to the right:  Why:

a)

b)

3. Change in expected inflation will affect bond demand.  An increase in expected inflation will lower bond demand (Bd) for several reasons.  a) During inflationary periods, real (physical) assets do very well (real estate, gold, antiques, baseball cards, etc), so investors would shift out of bonds and stocks into real assets when expected inflation increases.  b) Also if Actual Inf > Expected Inf, the real returns on bonds will fall, so the lower real expected returns on bonds will cause a shift in demand for bonds.  Suppose investors had expected inflation over the next five years to be 3%, and now revise expectations to 5%, Actual Inflation > Expected lowers real returns, which lowers bond demand.  c) Also what effect will higher expected inflation have on expected future interest rates?

4. Risk - if the riskiness of bonds increases relative to other assets, the demand will fall, shift to the left. An increase in the riskiness of other assets, will increase the demand for bonds. Example: Economy goes into recession, junk bonds in general are now considered to be more risky (higher default rate).   Bd falls for junk bonds, Prices ______ and interest rates _____________ .

5. Liquidity - Increased liquidity of bonds, relative to other assets, increases demand for bonds (Bd).  Increased liquidity of other assets decreases the demand for bonds.

B. SHIFTS IN THE SUPPLY OF BONDS, depends on: expected profitability of investment opportunities, expected inflation, government activities.

1. Investment opportunities. The more profitable investment opportunities there are available, the greater the supply of bonds (the greater the demand for credit).  The fewer the opportunities, the lower the supply of bonds.  During economic expansions, businesses expand operations, and increase the Supply of Bonds ( Bs) or increase the Demand for Credit.  Companies are Net Debtors/Borrowers and their borrowing decisions are sensitive to current and expected overall economic conditions.  During an expansion, Bond Supply ______________, Bond prices ____________ and interest rates _____________ .   During a recession, Supply of Bonds falls, or the Demand for Credit falls, and Bond Prices ____________ and interest rates ______________ .   Therefore, interest rates are generally considered to be procyclical, increasing during an expansion and decreasing during a recession.

2. Expected inflation - An increase in expected future inflation raises the Demand for Credit now (Supply of Bonds increases).  Two reasons: a) higher int rates in the future, borrow now before interest rates rise and b) higher expected inflation lowers the real rate of interest, benefiting debtors.  Assuming: a) actual inflation is higher than was expected and b) fixed rate debt.

3. Government activity - Higher govt. deficits increase the Supply of Treasury bonds and shift Supply of Bonds (Bs) curve to the right, causing Bond Prices to __________ and interest rates to ___________.    Or we can view it as the Demand for Credit increasing.  "Crowding out" theory, that higher budget deficits put upward pressure on int rates and "crowd out" private sector borrowing (households and firms).  When the government is running a surplus, the Supply of Bonds decreases and the Bs shifts to the left.  Alternative economic theory of "rational expectations", present a challenge to crowding out theory:

CHANGES IN THE EQUILIBRIUM INTEREST RATE

Remember: 1) Ceteris paribus assumption and 2) bond prices and int rates are negatively related.

1. Changes in expected inflation - see p 107. Suppose that expected inflation was initially 5% and we start in equilibrium at Point 1, (P1 and i1).  Now expected inflation increases to 10%.  From our discussion above, we know that increases in expected inflation will LOWER bond demand and INCREASE bond supply.  Or: there will be an increase in the demand for credit and a decrease in the supply of credit.  Investors will shift away from bonds to real assets, decrease bond demand, decrease the supply of credit.  Firms will increase demand for credit, increase the supply of bonds, to try to take borrow now before interest rates rise.  Bond prices will FALL, interest rates will RISE by about the amount of increased inflation. Fisher effect: changes in exp inflation = changes in nominal int, could be a one to one relationship, see graph on page 108.   Equilibrium in bond market moves to Point 2, (P2 and i2).

2. Business cycle expansion - see page 109.  When economic growth is strong, the Demand for Credit by firms increases, Supply of Credit from households increases also.  Demand for bonds from investors increases, Supply of Bonds also increases.  Because of the strong economy, households and firms have more income/profits/wealth, so firms are borrowing MORE to expand, households are investing/saving MORE.   There are now two offsetting effects: Bs and Bd both INCREASE.  Effects:

a. Firms issue more bonds, Bs shifts out (increases) from Bs1 to Bs2, Bond Prices _________ and interest rates ___________.

b. Bond demand increases, Bd shifts from Bd1 to Bd2, Bond Prices _______________ and interest rates _____________.

Net effect: Shift in Bd LOWERS interest rates and Shift in Bs2 RAISES interest rates, so the overall theoretical effect on interest rates is UNCERTAIN unless we are know for sure which effect is stronger.  However, the empirical evidence (see graph, page 110) indicates that interest are PROCYCLICAL and RISE during an expansion and FALL during a recession.  Therefore, the graph on page 109 would be accurate, equilibrium goes from Point 1 to Point 2, interest rates FALL.  Reason:  Bs shifts by MORE than Bd shifts, so the overall net effect is that interest rate rise during expansion.

Loanable Funds Market: Demand for Credit increases, Supply of Credit increases, the net effect on int rates is theoretically uncertain. Depends on which curve shifts the most.  Int rates usually rise during an expansion and fall during a recession, indicating that the changes (shifts) in Demand for Credit are greater than the changes (shifts) in the Supply of Credit.

Reason: business borrowers are more sensitive than savers (households) to business conditions, business cycle and the state of the economy.  Expansion: firms will increase demand for borrowing more than savers will increase supply of credit.  Recession: firms will decrease demand for credit more than savers will decrease the supply of credit.  Savings rates are more stable over the business cycle than business borrowing.  Reason: because of social security, pension funds, unemployment benefits, etc.

Questions: Why are interest rates so LOW in Japan??  How do savings rates affect interest rates in U.S.?  How does the budget surplus affect interest rates?  Treasury bought back \$30B in outstanding debt in 2000, see p. 112.

LIQUIDITY PREFERENCE FRAMEWORK: S AND D FOR MONEY

Another economic framework to analyze the behavior of interest rates is to look at the S and D for money, which also determines the equilibrium interest rate.  Liquidity Preference also helps to understand the Fed policy and the effect that it has on interest rates, since the Fed controls the MS directly and interest rates indirectly. Issues:
a) How does monetary policy affect interest rates?  b) How does the effect of monetary policy on interest rates differ in the short-run (SR) vs. long-run (LR)?

Assumptions of Liquidity Preference Theory:

1. Money pays no interest. Money = Cash + non-interest checking accounts (demand deposits).

2. There are two main assets to store wealth - bonds (interest bearing) and money/cash (int = 0%).

Bs + Ms = Bd + M which says that the Supply of assets (bonds and money) has to equal the Demand for assets (bonds and money).

Interest rates change to clear both bond and money market, bring about equilibrium.

Bs - Bd = Md - Ms and in equilibrium both sides equal 0, so that:
Bs = Bd and Ms = Md,

which implies that both the money market and bond market clear in equilibrium, and interest rates change to "equilibrate" the markets, resulting in market-clearing. We can either look at interest rates in the bond market or money market, and we get the same results, since interest rates "equilibrate" both markets.

3. Int rate = bond rate = opportunity cost of holding money/cash (which pays 0 interest).  Interest rate in the money market is the foregone interest from holding bonds, or the interest rate on bonds (or savings accounts).  If you hold \$1000 in cash (i = 0%), you forgo, or give up, the opportunity to earn interest by holding \$1000 of bonds @ market interest rate.

Md and int rates are inversely related. See p. 115.  At high interest rates (25%) the opp cost of holding money is very high, and the Md would be very low (Point A, \$100B).  At an interest rate of 5%, the cost of holding money is very low, Md would be much higher, (\$500B, Point E).  Md slopes downward, reflecting the negative relation btwn Md and interest rates.

Example: \$10m @ 15% interest for three days is \$12,500.  Story of Rockwell.

Ms is controlled by the FRS, so it is a vertical line.  Equilibrium at Point C, int rate = 15%.

If i = 25%, Ms > Md, people would have excess money holdings.  They would attempt to get rid of money by buying bonds, bidding up bond prices, reducing int rates until 15%.

If i = 5%, Md > Ms, excess demand for money, people want more money than they currently have.  To get money, they sell their only other asset - bonds - to get money. Selling pressure would lower the price of bonds and raise the interest rate back to 15%.  Market forces of S and D for Money would force the int rate to 15%, resulting in market clearing, equilibrium condition.   Interest rates fluctuate daily/hourly to continually bring about equilibrium in the bond and money markets.

SHIFTS IN THE DEMAND FOR MONEY -

Two factors will cause the demand for money to shift.

1. Income Effect - two factors. a) As the economy expands and grows, income and wealth increase.  As wealth grows, people will now want more money as a store of value, money as an asset.  Second, as income and wealth grow, people will increase consumption and will want more money to carry out transactions.  People buy more stuff when income increases, Md goes up.  Therefore, higher income will cause Md to increase, shifting Md curve to right, see page 118.

2. Price Level Effect - People care about what money can buy (purchasing power), so they are concerned about the real value of money holdings, not the nominal value.  People care about the purchasing power of their money holdings, will attempt to maintain constant purchasing power of their money, or will attempt to maintain constant real money holdings.  If you normally like to carry \$100 cash every week, and prices double, you will now want to hold \$200 cash, to carry out the same transactions.  As the Price Level increases, Md increases.  See p. 118.

SUMMARY: Md is POS related to INCOME and the PRICE LEVEL and NEG related to INT RATES.

Application: Economic expansion, what happens to interest rates in the MS/MD model?  page 117.

SHIFTS IN THE SUPPLY OF MONEY-

FRS controls Ms.  An increase in Ms will shift MS curve to the right, and int rate will DECREASE.   A decrease in Ms will shifts MS to left, and int rate will INCREASE.   Ms and Int Rates are inversely related, see page 118.

CHANGES IN THE EQUILIBRIUM INTEREST RATE - Pages 118-119 summarize the factors that affect interest rates in the Liquidity Preference model, and graphically show the possible changes.

MONEY AND INTEREST RATES

In the Liquidity Preference model, when the MS is increased, interest rates initially fall, this is called the liquidity effect.  When the MS is decreased, interest rates initially rise.

How does FRS increase the MS?  ______________________ How does that affect bond prices? ___________________  Int rates? ____________________

How does FRS decrease the MS? ______________________ How does that affect bond prices? ____________________ Int rates? _____________________

However, the liquidity effect is only the SHORT RUN effect.  A change in the MS takes 12-36 months for the FULL, LONG RUN effect, and have its full impact on the economy (12-18 months for output and employment, up to 36 months for price level and interest rates).  After the initial liquidity effect (MS goes up and int rates fall, ceteris paribus), there are three other effects that typically RAISE interest rates over time. Things DON'T stay the same in the long run.  Over time, the increase in the MS has the following long-run effects:

1. INCOME EFFECT - increases in MS are expansionary, national income and wealth go up, maximum expansionary effect happens 12-18 months AFTER the expansion.  One reason for expansion is that lower interest rates stimulate the economy - WHY??  As income rises, both the Loanable Funds model and Liquidity Preference model predict that interest rates will rise. MS goes up, income goes up, MD INCREASES, and interest rates go up over time, as MD shifts OUT.  Interest rates are PROCYCLICAL, rise during an expansion.

2. PRICE LEVEL EFFECT - increase in MS causes the price level to increase, gradually over time (takes up to 36 months).  As price level rises, MD shifts out and interest rates rise over time.  Think of the Fisher effect: R = r + INFa.  MS goes up, Price level rise, inflation increases, nominal interest rate increase (over time).

3. EXPECTED INFLATION EFFECT.  Loanable funds framework predicts that higher expected inflation will increase interest rates, page 107 (since B increases and Bd decreases).  If the increase in MS leads people to expect higher inflation in the future, interest rates may increase immediately to reflect higher future inflation, especially if people are rational and forward looking (rational expectations).  Think of Fisher effect: R = r + INFe

The difference between Price Level Effect and Expected Inflation Effect:  Price level effect is the effect of the ACTUAL level of inflation, and reaches its max effect is in the future. Remains even after prices have stopped rising.  Expected inflation effect is the effect of inflationary expectations and is the highest in the beginning and dies down to zero after prices have stopped rising.

SUMMARY: Liquidity Effect initially LOWERS interest rates in SR, but the Income Effect, Price Level Effect and Expected Inflation Effects all RAISE interest rates in LR.  Most likely Net Effect of an increase in MS: Lower int rates in SR, higher interest rates in LR.  Most likely Net Effect of a decrease in MS: Higher interest rates in SR, lower interest rates in LR.

How does a higher growth rate of money affect interest rates over time?  See page 123.  Most likely scenarios: Panels b and Panel c.  There is no evidence to support money growth permanently lowering interest rates, all evidence points to money growth raising interest rates.

Panel b:

Panel c:

Empirical evidence, see page 125.  MS growth is associated with higher interest rates.  Panel (a) on page 123 is not possible. Either (b) or (c) has to prevail. Interest rates go up in the long run, the only question is whether there is a short term liquidity effect or not. Most evidence supports a short term liquidity effect.  Notice especially the periods of high money growth in 1972-1973 and 1975-1976, where we can see the initial liquidity effect in SR, and the subsequent periods of higher interest rates in LR.

Problems: 2, 6, 7, 12, 15