Department of Economics
Saint Louis University
Professor: Rapach
Fall 2008
ECON 420
Money and Banking

Chapter Outline for “Chapter 5—The Behavior of Interest Rates,” Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, Eighth Edition (New York, N.Y.: Addison-Wesley, 2006)

DETERMINANTS OF ASSET DEMAND

1.      Wealth

2.      Expected return

3.      Risk

4.      Liquidity

Wealth

Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.

Expected Returns

An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset.

Risk

Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.

Liquidity

The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded.

Theory of Asset Demand

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.

See Table 1

SUPPLY AND DEMAND IN THE BOND MARKET

demand curve: shows the relationship between the quantity demanded and the price when all other economic variables are held constant

Demand Curve

i = R^e = (F – P)/P

See Figure 1

Supply Curve

supply curve: shows the relationship between the quantity supplied and the price when all other economic variables are held constant

Market Equilibrium

market equilibrium: occurs when the amount that people are willing to buy (demand) equals to amount that people are willing to sell (supply) at given price

B^d = B^s

excess supply: situation in which the quantity of bonds supplied exceeds the quantity of bonds demand

excess demand: situation in which the quantity of bonds demanded exceeds the quantity of bond supplied

Supply and Demand Analysis

CHANGES IN EQUILIBRIUM INTEREST RATES

Shifts in the Demand for Bonds

See Table 2

Wealth

In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right.

See Figure 2

When income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left.

Expected Returns

Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shifts the demand curve to the left.

Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right.

An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to decline and the demand curve to shift to the left.

Risk

An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left.

An increase in the riskiness of bonds of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right.

Liquidity

Increase liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right.

Increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left.

Shifts in the Supply of Bonds

See Table 3

Expected Profitability of Investment Opportunity

In a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right.

See Figure 3

In a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shifts to the left.

Expected Inflation

An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right.

Government Budget

Higher government deficits increase the supply of bonds and shift the supply curve to the right.

On the other hand, government surpluses, as occurred in the late 1990s, decrease the supply of bonds and shift the supply curve to the left.

APPLICATION Changes in the Interest Rate due to Expected Inflation: The Fisher Effect

See Figure 4

See Figure 5

When expected inflation rises, interest rates will rise.

Fisher effect: increase in interest rates resulting from an increase in expected inflation

APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion

See Figure 6

See Figure 7

SUPPLY AND DEMAND IN THE MARKET FOR MONEY: THE LIQUIDITY PREFERENCE FRAMEWORK

liquidity preference framework: determines the equilibrium interest rate in terms of the supply of and demand for money

B^s + M^s = B^d + M^d

B^s – B^d = M^s – M^d

M^s = M^d ® B^s = B^d

opportunity cost: amount of interest (expected return) sacrificed by not holding the alternative asset—in this case, a bond

See Figure 8

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 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 to increase and the demand curve to shift to the right.

Shifts in the Supply of Money

An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right.

APPLICATION Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply

See Table 4

Changes in Income

When income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise.

See Figure 9

Changes in the Price Level

When the price level increases, with the supply of money and other economic variables held constant, interest rates will rise.

Changes in the Money Supply

When the money supply increases (everything else remaining constant), interest rates will decline.

See Figure 10

APPLICATION Money and Interest Rates

1.      Income Effect. Income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income.

2.      Price-Level Effect. Price-level effect from an increase in the money supply is a rise in interest rates in response to the rise in the price level.

3.      Expected-Inflation Effect. The expected-inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate.

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?

See Figure 11

See Figure 12

QUESTIONS AND PROBLEMS: 1, 3, 5, 7, 10, 12, 16, 18, 20