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?

• A change in wealth. As wealth increases, people will buy more bonds at each and every price, and the demand for bonds rises, or shifts right. So when an expanding economy increases both income and wealth, we expect bond demand to increase too.
• A change in expected interest rates. For bonds with more than a year to maturity, rising interest rates in the future will decrease the value of the bond (and hence the expected return). At each and every price, fewer bonds will be demanded. Bond demand will fall, or shift left when expected future interest rates fall. The size of the decrease will be larger for longer term bonds.
• A change in expected inflation. If investors expect the inflation rate to rise, then they expect the real return on their bond to fall, as future payments are able to buy less. Higher inflation expectations decrease bond demand.
• A change in the relative risk of bonds. At any given price or expected return, if bonds become riskier, people will switch to less risky assets. An increase in the relative risk of bonds with decrease bond demand.
• A change in the relative liquidity of bonds. If it becomes harder to resell bonds in the bond market, people will switch to assets that are easier to resell. A decrease in the relative liquidity of bonds will decrease bond demand.

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?

• A change in expected profits. Firms issue bonds to finance the purchase of capital equipment and the expansion of production. This makes sense only if this expansion is expected to be profitable. As economic conditions become more favorable, expected profitability rises and bond supply will increase or shift right.
• A change in expected inflation. While rising inflation decreases the real return for those who buy bonds, it decreases the real cost of borrowing for those who issue bonds: For a given nominal interest rate (and bond price), higher inflation means a lower real interest rate. Thus, higher expected inflation increases bond supply.
• A change in government borrowing. If the government runs budget deficits, the U.S. Treasury must issue additional bonds to finance the shortfall in tax revenue. At each and every bond price, the quantity supplied increases, so the bond supply curve shifts right. Conversely, federal budget surpluses could lead the U.S. Treasury to buy back and retire bonds with the excess revenue and decrease bond supply.

• The demand for bonds is the same as the supply of loanable funds. Those who buy bonds are providing loans to others and are receiving interest.
• The supply of bonds is the same as the demand for loanable funds. Those who supply or issue bonds are borrowing money and paying interest.

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.

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?

• A change in income. A higher income increases money demand for two reasons. First, people buy more stuff and need money to carry out the transactions. Second, people save more, some of which takes the form of money.
• A change in the price level. If I buy my lunch every day and the cafeteria prices double, I will need twice as much cash during the week if I still want to buy lunch. As the price level rises, people need to hold more money to conduct the same level of transactions. An increase in the price level will increase money demand.
• A change in technology. This one is not in your book, but I added it because I think it is important. As electronic payment systems become more widespread, it is not necessary to carry as much cash. People do not have to hold as much M1 since it is easier to access a savings account or a money market account, both of which pay interest. Technology like ATM/debit cards will decrease money demand, shifting the money demand curve to the left.

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?

• A change in Federal Reserve policy. If the Federal Reserve increases the money supply, then the money supply curve will shift right. We will discuss this process in greater detail in chapters 14-18.

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 increase in the money supply lowers the interest rate. This is the liquidity effect.
• Lower interest rates could then have an expansionary effect on the economy, which would increase income, money demand and the interest rate. This is the income effect.
• The increase in the money supply could increase the price level, money demand, and the interest rate. This is the price-level effect.
• If repeated increases in the money supply are expected, this could increase inflationary expectations. Back in part I, we saw how that leads to higher interest rates in the bond market framework. This is the expected inflation effect.

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.