5 - The Behavior of Interest Rates

Chapter 5
The Behavior of
Interest Rates
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
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Theory of Portfolio Choice
Holding all other factors constant:

1. The quantity demanded of an asset is positively related
to wealth
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
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
(downward sloping demand curve)
• At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is lower: a positive relationship
(upward sloping demand curve)

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: www.federalreserve.gov/releases/H15/data.htm.

Application: The case of Japan
• In the late 1990s and early 2000s, Japan

experienced a prolonged recession,
accompanied by deflation (negative inflation).
Use the theory of portfolio choice to explain
what happens to Japanese interest rates.
• In recent years, the Japanese central bank
moved a key interest rate below zero in an
effort to stimulate Japan’s struggling
economy. Again based on portfolio choice
theory, give your forecast for the bond
markets (Japan and elsewhere).
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 ).

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.

Figure 8 Equilibrium in the
Market for Money

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

in Income or the Price Level

in the Money Supply

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

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.

Figure 12 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.

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Chapter 5

• Wealth: the total resources owned by the

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Holding all other factors constant:

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• At lower prices (higher interest rates),

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• Occurs when the amount that people are

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• Expected profitability of investment

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Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.

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• In the late 1990s and early 2000s, Japan

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• As the interest rate increases:

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• Shifts in the demand for money:

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• Assume that the supply of money is

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• Liquidity preference framework leads to the

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• Price-Level effect predicts an increase in the

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Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

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