LECTURE 3. Chapter # 5: Understanding Interest Rates: Determinants and Movements

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1 LECTURE 3 Hamza Al alk Econ 3215: oney and ankng Wnter 2007 Chapter # 5: Understandng Interest Rates: Determnants and ovements The Loanable Funds Approach suggests that nterest rate levels are determned by the forces of supply and demand for loanable funds new funds avalable for nvestment. The nteracton between the amounts of funds avalable for nvestment by lenders (the supply of loanable funds), and the quantty of funds desred by borrowers (the demand for loanable funds) s assumed to generate a market-clearng prce that s, an equlbrum nterest rate. Suppose funds are to be rased by the ssuance of bonds. Then, the lower the prce of a bond, the more of them lenders wll want to hold, that s, d or (LF S ). Smlarly, the hgher the prce of a bond, the larger the quantty prospectve debtors wll want to ssue, that s S or (LF D ). Prce of bond (PV) S PV* d * Qty of bonds 1

2 However, we are not nterested n bond prces, but the determnaton of nterest rate. For ths purpose, we wll explot the negatve relatonshp between the prce of bonds and the nterest rate. Accordngly, we may call bond demand the supply of loanable funds and bond supply the demand for loanable funds. arket Equlbrum: Nomnal nterest rate d s d = or LF s = LF LF s (= d ) * LF d (= s ) * Qty of bonds Shfts n the Supply of Loanable Funds (or shfts n the demand for bonds). Lke any asset n general, the demand for bonds s a functon of (depends on) four varables. These are: Wealth (W), Expected Return (RET e ), Rsk (σ ), and Lqudty (L). ore specfcally, ond Demand = f ( W, RET e, σ, L) (+) (+) (-) (+) 1. Wealth (W): Economc actvty wealth, d (LF s ) d shfts out to rght or LF s shfts down (or rghtward). 2

3 P LF s As W As W d 2. Expected Return (RET e ) n future, RET e for long-term bonds, d shfts out to rght and LF s shfts down. e π relatve RET e, d shfts out to rght and LF s shfts down. 3. Rsk (σ ) σ d d shfts out to rght and LF s shfts down. σ of other assets d down. d shfts out to rght and LF s shfts 4. Lqudty (L) L of bonds d d shfts out to rght and LF s ncreases. L of other assets, d d shfts out to rght and LF s ncreases. Shfts n the Demand for Loanable Funds (or shft n the supply of bonds) 1. Proftablty of Investments As the proftablty of nvestment s, s shfts down (ncreases) 3

4 and LF d shfts out to the rght. P s LF D 2. Government Polces Governments typcally borrow more durng recessons than durng boom perods. Durng a recesson, ther tax revenues but ther spendng on unemployment nsurance and other socal programs. The resultng defct may have to be fnanced by borrowng. So, government defct s, s shfts down (rght) and LF d shfts out to the rght. 3. Expected Inflaton As e π, s, s shfts down and LF d shfts out to the rght. The Lqudty Preference Approach: Supply and Demand n the market for money. Lqudty Preference: the desre to hold cash n preference to an alternatve fnancal asset, such as a bond. It s, n other words, the demand for money. asc assumpton: There are two man categores of assets that people use to store ther wealth (W): money () and bonds (). That s, W = +. 4

5 If wealth remans constant, we can wrte W = 0 or 0 = + = Thus, any change n the stock of bonds s exactly offset by changes n the money stock under the assumpton of unchangng wealth. Put dfferently, f the bond market s n equlbrum, the money market must also be n equlbrum. So, or d d s + = + s d = d s s s d s d Thus, excess demand ( < 0 ) or excess supply ( > 0 ) of money must s d s d be dentcal to an excess supply ( > 0 ) or an excess demand ( < 0) for bonds. In ths sense, the lqudty preference and the loanable funds frameworks are smlar. The Demand for oney The desre to hold money s assumed to be a functon of three factors: the nterest rate, real ncome, and the prce level. Remember, accordng to the narrow defnton of money, t s an asset that earns lttle or no nterest. Thus, the holders of lqudty ncur the opportunty cost of not holdng an asset that could earn nterest ncome. Does t make sense then for an ndvdual to hold any money at all? Yes, because holdng money s requred for transacton purposes: 5

6 Thus, money demand functon can be wrtten as: d = f ( P, Y, ) where Y s real ncome and s nomnal nterest rate, and P s the general prce level. d = P Sometmes, wrtten as: f ( y,) Nomnal nterest rate, d (for a gven Y and P) Shfts n the Demand for oney Qty of money, A hgher level of ncome causes the demand for money to ncrease and the demand curve shft to the rght. Smlarly, a rse n the prce level causes the demand for money to ncrease and the demand curve shft to the rght. As Y or as P d d 6

7 Supply of oney It s conventonal to assume that the supply of money s entrely under the control of the central bank and that t s unresponsve or unrelated to nterest rate levels. Thus, the supply of money s a vertcal lne. s Shfts n the Supply of oney An ncrease n the money supply engneered by the central bank wll shft the supply curve for money to the rght. s s 7

8 Equlbrum n the oney arket: d = s s * d (for gven Y) * 8