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Copyright 2011 Pearson Canada Inc. 5 - 1
Chapter 5
The Behaviour of Interest Rates
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Determinants of Asset Demand
1. Wealth - the total resources owned by the individual,including all assets
2. Expected Return - the return expected over the next
period on one asset relative to alternative assets3. Risk - the degree of uncertainty associated with the
return on one asset relative to alternative assets
4. Liquidity - the ease and speed with which an assetcan be turned into cash relative to alternative assets
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Theory of Asset Demand
1. The quantity demanded of an asset is positivelyrelated to wealth.
2. The quantity demanded of an asset is positively
related to its expected return relative toalternative 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.
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Supply and Demand for Bonds I
Bond Demand: At lower prices (higher interest
rates), ceteris paribus, the quantity demanded
of bonds is higheran inverse relationship.
Bond Supply: At lower prices (higher interest
rates), ceteris paribus, the quantity supplied
of bonds is lowera positive relationship.
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Supply and Demand for Bonds II
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Derivation of Bond Demand Curve
i = RETe = (F-P)/P
P=$950
i=($1000 - $950)/$950 = 0.053 = 5.3%
Bd = $100 billion
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Market Equilibrium
Occurs when the amount that people are willing tobuy (demand) equals the amountthat people are willing to sell (supply) at a givenprice.
Bd = Bs determines the equilibrium (or marketclearing) price and interest rate
When Bd > Bs excess demand price will rise and
interest rate will fall When Bd < Bs excess supply price will fall and
interest rate will rise
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Shifts in the Demand for Bonds II
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Shifts in the Supply of Bonds I
Expected profitability of investmentopportunities - in an expansion, the supplycurve shifts to the right
Expected inflation - an increase in expectedinflation shifts the supply curve for bonds tothe right
Government activities - increased budgetdeficits/surpluses shift the supply curve to theright/left
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Factors that Shift the Supply Curve of Bonds
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Shifts in the Bond Supply Curve
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Interest Rate Changes from Expected Inflation I
The Fisher Effect:
Increases in expected inflation Bs shifts to
right
Increases in expected inflation Bd shifts
right
At the new equilibrium, bond prices have
fallen and the interest rate has increased.
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Interest Rate Changes from Expected Inflation II
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Response to a Business Cycle Expansion I
During a business cycle expansion:
Income and Wealth are increasing leading to
an increase in bond demand.
The supply of bonds also increases as firms
are more willing to borrow.
This leads to an increase in the equilibrium
interest rate
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Response to a Business Cycle Expansion II
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Business Cycles and Interest Rates
Business cycle expansions lead to increased interest rates
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Response to a Lower Savings Rate
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Liquidity Preference Framework I
Equilibrium interest rates are determined by
the supply and demand for money
Two ways to hold wealth: money and bonds
Total wealth equals total amount of money
and bonds.
Bs + Ms = Bd +Md
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Liquidity Preference Framework II
Rearrange terms:
Bs - Bd = Md Ms
If the bond market is in equilibrium then the
money market must also be in equilibrium
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Liquidity Preference Framework III
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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 shiftto the right
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Shifts in the Supply of Money I
Assume that the supply of money is controlled
by the central bank.
An increase in the money supply engineered
by the Bank of Canada
will shift the supply curve for money to the
right.
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Shifts in the Demand and Supply of Money II
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Changes in the Demand for Money
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Changes in the Supply of Money
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Money Supply and Interest Rates I
Income effect of an increase in the money supply is arise in the interest rate in response to a higher level ofincome.
Price-Level effect of an increase in the money supply isa rise in interest rates in response to the rise in theprice level.
The expected-inflation effect of an increase in the
money supply is a rise in interest rates in response tothe rise in the expected inflation rate.
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Money Supply and Interest Rates II
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Money Growth and Interest Rates