chapter 6: learning objectives interest rate level determination:

Chapter 6:Learning Objectives

Interest Rate Level Determination:


Interest Rate Level Determination: Loanable funds vs. Liquidity preference



Equilibrium Determination & Changes



Equilibrium Determination & Changes Applications:




Fisher effect




Fisher effect interest rates over the business cycle




Fisher effect interest rates over the business cycle the impact of a tight monetary policy

A Selection of Yields over Time

0

4

8

12

16

20

60 65 70 75 80 85 90 95 00

Per

cent

per

yea

r

Year

Corporatepaper rate

Long-termCanada bondyield

Treasury bill rate

Loanable Funds Theory

Focus is on the Market for bonds


Focus is on the Market for bonds Bond demand (Bd) is determined by investors’

preferences



preferences Bond supply (Bs) is determined by borrowers’

preferences




preferences For discussion purposes, ASSUME a one-year

discount bond $PD is inversely related to R (=[$FV-$PD]/$PD




preferences For discussion purposes, ASSUME a one-year discount

bond $PD is inversely related to R (=[$FV-$PD]/$PD)

The interaction between Bond demand and supply determines the equilibrium interest rate

BOND DEMAND=SUPPLY OF LOANABLE FUNDS

From Bond demand/supply to Loanable funds demand/supply

From Bond demand/supply to Loanable funds demand/supply

BOND DEMAND=SUPPLY OF LOANABLE FUNDS

BOND SUPPLY=DEMAND FOR LOANABLE FUNDS

Figure 6.4. Market Equilibrium

E

Quantity of bonds

Nom

inal

inte

rest

rate

Excess supply

Excess demand

LFs

LFd

B*

R* •

A B••R0

C D••R1

Shifts in Loanable Funds demand/supply

DEMAND SIDE INFLUENCES

Wealth (+ve)

SUPPLY SIDE INFLUENCES



Wealth (+ve) Relative returns

(+ve)




Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve)




Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve)

Liquidity (+ve)




Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve)



Expected returns (+ve)





Expected returns (+ve) Govt policies (?)





Expected returns (+ve) Govt policies (?) Expected Inflation (+ve)




Figure 6.5. Shifts in the Demand for and Supply of Loanable FundsA. A Demand Shift

B

LFd2

R2

B2

•

•

Quantity of bonds

Nom

inal

inte

rest

rate

B1

R1A

LFd1

•

Figure 6.5. Shifts in the Demand for and Supply of Loanable FundsB. A Supply Shift

B2

LFs2

• •

Quantity of bonds

Nom

inal

inte

rest

rate

R1

B1

LFs1

Two Applications

The Fisher Effect: how inflation expectations affect nominal interest rates distinction between nominal and real interest rates (Recall: R=+e)Figure 6.6Figure 6.6

Two Applications

The Fisher Effect: how inflation expectations affect nominal interest rates distinction between nominal and real interest rates (Recall: R=+e)Figure 6.6Figure 6.6

The business cycle and interest rates: how changes in economic activity affect nominal interest ratesFigure 6.8Figure 6.8

Figure 6.6. The Fisher Effect

•

B*Quantity of bonds

Nom

inal

inte

rest

rate

LFs0

LFd0

R*0= *0 +e

0

E

LFd1

•

LFs1

R*1=*0+ 1e E’

Figure 6.8. Interest Rates in an Expansion

LFd1

•

B1

E’

LFs1

R*1

LFd0

•

Quantity of bonds

Nom

inal

inte

rest

rate

B0

R*0 E

LFs0

The Nominal Interest Rate and Economic Growth

-4

0

4

8

12

16

20

1960 1965 1970 1975 1980 1985 1990 1995 2000

Per

cent p

er ye

ar

Year

Treasurybill rate

Real GDP growth

Economics Focus 6.2: Measuring Real GDP

Product ExpenditureBase year

Quantities consumedBase year

PriceBase year

ExpenditureCurrent year

Quantities consumedCurrent year

PriceCurrent year

Haircut $300 30 $10 $400 20 $20

Watches $200 10 $20 $500 20 $25

GDP $500 $900

Economics Focus 6.2: Measuring Real GDP [Cont’d]

Fixed-Weight method(Base year prices)

Fixed-weight(Current year prices)

[20*$10+20*$20]/$500 =1.2GDP rises by 20%

$900/[30*$20+10*$25] = $900/$850=1.06GDP rises by 6%

Averaging the two yields:SQRT(1.20*1.06)= 1.13GDP rises by 13%

Liquidity Preference Theory

Focus is on the role of monetary policy


Focus is on the role of monetary policy Demand for money (Md) is determined by the

preferences of holders of money ( M1)



preferences of holders of money ( M1) Supply of Money is determined by the central

bank and the financial sector



preferences of holders of money ( M1) Supply of Money is determined by the central

bank and the financial sector The interaction of money demand/supply

produces an equilibrium interest rate

Why Hold Money?

TRANSACTIONS MOTIVE: used in the buying and selling of goods and services

Why Hold Money?


PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events

Why Hold Money?


PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events

SPECULATIVE MOTIVE: represents one asset in a “portfolio” of assets

Analysis of Monetary Policy

Money Supply

Time

Money Supply

Time

Ms1

MS0

g=0

g=0

g><0g=0

Static Analysis Dynamic Analysis

= {[MSt - MS

t-1]/MSt-1} X 100

Figure 6.10. Contractionary Monetary Policy

Quantity of money

Nom

inal

inte

rest

rate

Ms0

Md0

ER*0

M*0

•

•

Ms1

R*1

M*1

Money Growth and Interest Rates

-5

0

5

10

15

20

25

1965 1970 1975 1980 1985 1990 1995 2000

Perc

ent p

er ye

ar

Year

Average moneysupply growth

Treasurybill rate

The (Dynamic) Link Between Money Growth and the Interest Rate

Time

0

1

2

R

R0

R1

R2

Time

The Liquidity Trap

When nominal interest rates are close to zero can monetary policy be effective

The Liquidity Trap

When nominal interest rates are close to zero can monetary policy be effective?

It has been suggested that monetary policy is then like pushing on a string

The Liquidity Trap

When nominal interest rates are close to zero can monetary policy be effective?

It has been suggested that monetary policy is then like pushing on a string

But, monetary policy is more than just changing the money supply or even changing interest rates. Its about changing expectations of future inflation. The trap can, in principle, be avoided

Summary

There are 2 theories of interest rate determination: the loanable funds and liquidity preference models

Summary


Loanable funds focuses on the bond market

Summary


Loanable funds focuses on the bond market Liquidity preference focuses on the demand for money

and the role of monetary policy

Summary


Loanable funds focuses on the bond market Liquidity preference focuses on the demand for money

and the role of monetary policy Equilibrium interest rates change because of changes in

liquidity, risk, expectations, govt and central bank policies

chapter 6: learning objectives interest rate level determination:

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