Chapter 5: The Behavior of Interest Rates

Now that we know how to measure interest rates, we want to examine why interest rates fluctuate up and down. The answer lies with the laws of supply and demand in financial markets. That's right, there is no escaping supply and demand in an economics class.

I. Asset Demand

Bonds are just one example of an asset, which can be any store of value. Other examples include money, stocks, real estate, and gemstones. In choosing which asset will be used to store and accumulate wealth, and how many, we look at the following factors:

A. Wealth

With greater wealth comes greater resources with which to purchase assets. So greater wealth means an increase in the quantity demanded of assets, other factors held constant.

B. Expected Returns

Recall from chapter 4 that the return on an asset measures the gain from holding an asset over a given period. When deciding whether or not to purchase an asset, we form an expectation of the return based on anticipated payments (coupon payments, dividends) and price changes. This is the expected return. If the expected return of an asset changes relative to other assets, this affects the decision whether or not to purchase the asset. An increase in the relative expected return of an asset will increase the quantity demanded of that asset, other factors held constant.

C. Risk
Risk is the amount of variation in an asset's possible return. For example, suppose real estate in Oswego appreciates 2% annually half the time, and 5% annually half the time (yeah, right). The expected return is 3.5%. Now suppose real estate in Scriba appreciates 3.5% every year. Both assets have the same expected return of 3.5%. However, real estate in Oswego, in this example, is riskier because the actual return varies.

Evidence about investor behavior suggests that most people are risk-averse; i.e. for assets with identical expected returns, they will prefer the asset with lower risk. Thus, if an asset's risk increases relative to other assets, the quantity demanded of that asset will fall, other factors held constant.

D. Liquidity
Recall that liquidity refers to how quickly and cheaply an asset can be converted to cash. Real estate is not liquid, since is takes time to find a buyer and sellers typically pay commissions of 6-7% to real estate agents to find a buyer. U.S. Tbills are very liquid, with many buyers and small bid-ask spreads. Larger markets, with many buyers and sellers are going to be more liquid. For example, real estate in New York City is more liquid than real estate in Oswego because the NYC market is so much larger.

The table below sums up the impact of the four factors on the quantity demanded of an asset:
 
Variable
Change in Variable
Change in Quantity Demanded 
Wealth
increase
increase
Expected Return (relative)
increase
increase
Risk (relative)
increase
decrease
Liquidity (relative)
increase
increase

II.  The Bond Market

Now let's take a look at how bond buyers and bond sellers determine the level of interest rates, and how changes in market conditions result in changing interest rates. Our discussion of asset demand above is important in deriving the supply and demand curves.

A. The Demand for Bonds

Bond demand is based on the behavior of those who buy bonds, or lenders/savers.
Consider a zero coupon bond with a face value of $1000. Suppose the bond has 1 year until maturity, and the expected holding period is one year. Then the bond's expected return is equal to its yield to maturity:

Using the formula above, we can calculate the expected return for various prices:
 
Bond Price
i = exp. return
700
42.86%
750
33.33%
800
25%
850
17.65%
900
11.11%
950
5.26%

As the bond price rises, both the yield to maturity and the expected return fall. As the expected return falls, the quantity demanded of the bond will fall, given our discussion of asset demand. So the bond demand curve looks like this:

At higher prices, the quantity demanded of bonds falls. Also, note that higher bond prices are associated with lower interest rates because bond prices and interest rates are negatively related.

What shifts the bond demand curve?

B.  The Supply of Bonds

To determine the level of interest rates, we also need the bond supply curve, which models the behavior of those who issue bonds, or borrowers. Higher bond prices mean lower interest rates, which encourage borrowing, ceteris paribus. So the bond supply curve slopes up with respect to bond prices:

In the bond market above, the equilibrium interest rate is 17.65%.

What shifts the bond supply curve?

Two things to remember about the bond market: C.  Equilibrium Interest Rates

Any shift in the bond demand and/or bond supply curves implies a new equilibrium interest rate. Thus, when we observe fluctuating interest rates in the economy, the root cause is changes in the factors affecting bond supply and bond demand. Let's look a couple of applications.



Example 1: An increase in expected inflation (The Fisher Effect)
Suppose expected inflation is initially at about 3% with initial bond supply and demand curves of Bs and Bd (blue). The equilibrium interest rate is 5% (point 1):

Now suppose inflation expectations rise to 4%. Bond demand decreases (along with the expected real return) and bond supply increases (as the real cost of borrowing declines) to Bs' and Bd' (red). The new equilibrium interest rate is definitely higher (and the bond price lower):

The total impact on the quantity of bonds here is zero, but in general depends on the size of the shifts in the bond demand and supply curves. So the Fisher effect is this: when expected inflation rises, nominal interest rates will rise.



Example 2: An economic slowdown
Let's start again with initial bond supply and demand curves of Bs and Bd (blue). The equilibrium interest rate is 5% (point 1):

Now suppose we are in the first quarter of 2001, in the midst of an economic slowdown and concern about a recession. Again this condition will affect both the bond demand and bond supply curves. With the slowdown comes a decline in income and wealth the demand for bonds will decrease to Bd''. The slowdown also has negative implications for profits, so bond supply also declines to Bs'':

In general, where both bond supply and bond demand decrease, the total effect on the equilibrium interest rate is uncertain. Here the shift in bond supply is larger than the shift in bond demand, so the interest rate falls. This is consist with the data on interest rates and the business cycle: nominal interest rates tend to fall during recessions and rise during expansions (see figure 8, page 110).

The table below summarizes that impact of various factors and the bond market and the equilibrium level of interest rates:
(Note: ignore table 2 in your book, it has a couple of typos in it)

The Effect of Selected Variables on the Bond Market and Equilibrium Interest Rates.
Variable
Change in Variable
Change in Bd
Change in Bs
Change in i
Wealth
increase
increase
decrease
Expected Interest Rates
increase
decrease
increase
Expected Inflation
increase
decrease
increase
?
Relative Risk
increase
decrease
increase
Relative Liquidity
increase
increase
decrease
Expected Profitability of Firms
increase
increase
increase
Government Deficits
increase
increase
increase

II. Liquidity Preference: Money Demand and Money Supply

Modeling the demand and supply of money is an alternative to the bond market framework for determining the equilibrium interest rate. This liquidity preference framework was developed by John M. Keynes.

A. Money Demand

When Keynes developing this framework, his definition of money included currency and checking accounts, which at the time earned no interest. So money had no rate of return. However bonds, an alternative store of value, do earn interest. Why hold money? To buy stuff. You cannot go to McDonald's and hand them a U.S Tbill. So the decision to hold money or hold bonds is a tradeoff between liquidity and return.

The interest rate is the opportunity cost of holding money. It represents what must be given up in order to hold money and get the desired liquidity. Hence, the decision about how much money to hold is the preference for liquidity. A higher interest rate implies a higher opportunity cost of holding money, so the money demand curve is downward sloping with respect to the interest rate:

What shifts the money demand curve?

B. Money Supply

If we assume that the central bank (in the U.S., the Federal Reserve System) controls the money supply, they can fix it at whatever quantity they want. This means that the money supply curve is vertical at that quantity:

What shifts the money supply curve?

C. Money and Interest Rates

Together the money demand and money supply curves make up the market for money and determine an equilibrium interest rate. Shifts in the money supply and/or money demand curves imply a new equilibrium interest rate. Some examples:


Example 3: If an economic expansion increases incomes, then money demand increases and the interest rate rises.


Example 4: If an economic expansion pushes up price level, then money demand increases and the interest rate rises.



Example 5: If the Federal Reserve increases the money supply, then the interest rate falls.

This last example is a matter of considerable disagreement among monetary economists. The fact is, an increase in the money supply has several effects that pull interest rates in opposite directions:

The total impact of money supply changes on the interest rate depend on which effects are more powerful. Looking at data on interest rates and money supply growth (figure 14), there is little evidence that the liquidity effect dominates, especially in the long run..

FYI: Related Links

The Federal Reserve Economic Database (FRED) This site contains daily, weekly, and monthly data on all types of interest rates.

Points of Interest A Federal Reserve publication that covers how the general interest rate level is determined, along with why we observation so much variation among individual interest rates. You must have Adobe Acrobate Reader to view this or any PDF file. It is free to download at the link I have provided.