Boğaziçi University Department of Economics Money, Banking and Financial Institutions L.Yıldıran

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1 Chaper 3 INTEREST RATES Boğazç Unversy Deparmen of Economcs Money, Bankng and Fnancal Insuons L.Yıldıran Sylzed Fac abou Ineres Raes: Ineres raes Expanson Recesson Ineres raes affec economc acvy by changng agens neremporal (presen vs. fuure) decsons,.e., savng, borrowng, consumpon, and nvesmen. [Noe: Lfe Cycle Hypohess (Modglan) and ermanen Income Hypohess (Fredman) am o explan such neremporal decsons]. Tme Borrowers: (Demand for Funds) Ineres raes (.e., he cos of presen consumpon ) borrowng? Only subsuon effec consume less oday borrowng (o consume/nves) Ineres raes and borrowng are negavely relaed. Savers/Lenders: Ineres raes (.e., he cos of presen consumpon ) savng/lendng? (Supply of Subsuon effec consume less oday, save/lend more for omorrow Funds) (Endowmen) Income effec consume more oday save/lend less for omorrow Emprcally, subsuon effec s more lkely o domnae Ineres raes and savng are lkely o be posvely relaed. Ineres raes affec capal flows and FX raes oo. Rsng neres raes foser capal nflows and hence apprecaon of local currency. I) Why do neres raes flucuae n me? II) Why do we have so many dfferen neres raes a a ceran pon of me? I) Why do neres raes flucuae n me? Why do prces flucuae n general (e.g., ol prces)? Shocks affecng demand/supply condons + speculaon/manpulaon Ineres rae s he prce of borrowng. I s deermned, jus lke he prces of all oher goods and servces, by he neracon beween demand and supply condons n bond (loan) markes. So, flucuaons n neres raes can be explaned by he shocks affecng demand and supply condons n bond (loan) markes. Noce: Demand for Bonds Supply of Loans Supply of Bonds Demand for Loans Recall: Demand = f (preferences, prce, ncome, prces/quales of oher goods) Two frameworks o sudy neres raes: 1. Loanable Funds Framework (Demand for / Supply of Bonds) Classcs 2. Lqudy reference Framework (Demand for / Supply of Money) Keynesans 1

2 1. Loanable Funds Framework (Demand for / Supply of Bonds) Theory of (Real/Fnancal) Asse Demand: Asse Demand=f (prce(-), ncome(+), relave expeced reurn(+), relave rsk(-), relave lqudy(+)) Frms Supply and Households Demand n Bond Markes rce * B S (L D ) B D (L S ) * uany Movemens along demand/supply curves (only prce changes, ceers parbus): α 1/ Demand s negavely sloped,.e., ( ), D Supply s posvely sloped,.e., ( ), S Shfs n demand/supply curves (nonprce facors change, ceers parbus):. Shfs n Demand Curve Wealh (Boom) Expeced Fuure Expeced Inflaon (Real Reurn ) Relave Rsk Relave Lqudy Governmen Expendure. Shfs n Supply Curve Expeced rofably (Boom) Expeced Inflaon (Real Reurn ) Governmen Expendure 2

3 Examples: Shocks Affecng Demand/Supply Condons n Bond Markes (Economc Conjuncures) Expanson (Boom) (Genşleme) Recesson (Bus) (Daralma) ure Inflaon ure Deflaon [rolonged Recesson] Crss (Depresson) Sagnaon (rolonged Slow Growh) (Durgunluk) Sagflaon (Sagnaon+ Inflaon) Nom.In.Raes (Rsk ) Inflaon (Negave)? rce Level? Consumpon Oupu/Income Expanson ΔS > ΔD Recesson ΔS > ΔD ure Inflaon (nc ) (prof ) (rof ) (k r ) (nc ) (k r ) ure Deflaon Crss ΔS < ΔD Sagnaon (k r ) (prof ) (nc ) (prof ) (k r ) (rsk, nc ) Sagflaon (k r ) (nc ) (k r,prof ) 2. Lqudy reference Framework (Demand for / Supply of Money) Assumpon: Only wo markes for excess funds, Bond Marke and Money Marke. Equlbrum n Bond Marke Equlbrum n Money Marke (Walras Law) Money yelds zero rae of reurn (conrary o bonds) Opporuny cos of holdng money M D (Money Demand) = f (neres(-), ncome(+), prce level(+)) M D s negavely sloped, (opporuny cos of holdng money ) M d M S s oally conrolled by CB (smplfyng assumpon, no exacly rue n realy see Chp11) CB s Supply and Households (and Frms ) Demand n Money Marke Ineres M S M D uany 3

4 Shfs n demand/supply curves (nonprce facors change, ceers parbus): Income (boom) rce Level Lqudy (M S ) uany uany uany Counercyclcal Moneary olcy: CB adjuss M S o sablze prces / neres raes / FX raes Effecs of changng M S (expanson/conracon) on neres raes: Immedae: lqudy effec (-) M S shfs Afer some lags (hrough expecaons): ncome effec (+) M D shfs nflaon/prce level effec (+) M D shfs M S (moneary expanson n a conraconary perod): 3 Scenaros lqudy ncome+nflaon lqudy ncome+nflaon lqudy > ncome+nflaon lqudy < ncome+nflaon (slow adjusmen) lqudy < ncome+nflaon (fas adjusmen) M S (moneary conracon n an expansonary perod): 3 Scenaros T T lqudy ncome+nflaon lqudy ncome+nflaon lqudy > ncome+nflaon lqudy < ncome+nflaon (slow adjusmen) lqudy < ncome+nflaon (fas adjusmen) 4

5 Effecs of Counercyclcal Moneary olcy on Ineres Raes: Ineres raes Expanson M S Recesson M S Tme II) Why do we have so many dfferen neres raes a a ceran pon of me? 1. Rsk Srucure of Ineres Raes (Dfferences n Rsk) Defaul Rsk Rsk remum Governmen Secures (denomnaed n local currency) have no defaul rsk Rsk remum (R) = 0 AAA Hghes qualy (R=0) AA Hgh A Upper Medum Invesmen Grade Bonds BBB Medum BB Lower Medum B Speculave CCC CC Junk Bonds C D 2. Term Srucure of Ineres Raes (Dfferences n Maury) A Yeld Curve plos he yelds of governmen bonds wh dfferen maures. Noce ha R=0 for all such bonds,.e., all GBs have dencal defaul rsk. So, dfferences n yelds are only due o maures. Upward slopng (normal) Fla Downward slopng (nvered) Maury Maury Maury 5

6 Emprcal (Sylzed) Facs: a. Ineres raes for bonds wh dfferen maures move ogeher. b. When shor-erm neres raes are low (hgh), upward slope (downward slope) s more lkely. c. Shor-erm neres raes are more volale han long-erm neres raes. d. Yeld curves are almos always upward slopng. Theores o Explan Yeld Curves:. Expecaons Theory: (explans a, b and c) remse: Bonds wh dfferen maures are subsues. They should yeld comparable reurns. 2 e +1 : curren shor-erm (annual) neres rae (e.g., 1 year bond) : curren long-erm (annual) neres rae (e.g., 2 years bond) : expeced fuure shor-erm (annual) neres rae (e.g., 1 year bond of nex year) (1+ 2 ) (1+ 2 ) - 1 = (1+ ) (1+ e +1) = 1+ + e +1 + e ( + e +1) / n (long-erm n.rae) ( + e +1 + e e +n-1) / n where,, e +1, e +2,. e +n-1 are he expeced fuure shor-erm neres raes.. Segmened Markes Theory: (explans only d) remse: Bonds wh dfferen maures are no subsues. eople have dfferen preferences for maury. Bu, hey generally prefer shor-erm bonds o long-erm ones. Demand for shor-erm bonds s hgher (.e.,, ). Lqudy remum Theory: (explans all facs) Combnaon of he frs wo heores n = ( + e +1 + e e +n-1) / n + lqudy premum From yeld curves, we can nfer Marke s expecaon abou fuure shor-erm neres raes (e.g., FED raes) Curren moneary polcy sance (.e., gh or loose) Fuure ST raes wll rse Curren ST rae s low M s loose Fuure ST raes wll reman consan Fuure ST raes wll fall slghly Curren ST rae s hgh M s gh Fuure ST raes wll fall sharply Curren ST rae s very hgh M s very gh 6