A Supply-Demand Model of the Market for a Financial Asset

- See: Mishkin and Serletis, Ch. 5

- the textbook sets this up as a model of the market for “bonds”.

- the framework can be used to model other asset markets too.

- It is a model of a competitive market: a Supply-Demand model

- assumes many, "small", lenders and borrowers: price-takers

- What is on the axes?

- Horizontal axis: quantity of the asset -- (text: bonds). (measures the amount of lending and borrowing in this

market)

- Vertical axis: two possibilities

- price of the asset (P) (as in textbook); or

- yield (interest rate) of the asset (i): nominal, no inflation adjustment.

- recall: asset prices and asset yields are inversely related.

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- so: a curve that slopes up (down) with price on the axis,

slopes down (up) when yield is on the axis.Demand for Assets: Lender Behavior

- Who lies behind this? buyers of the asset , suppliers of “loanable funds”,

i.e. lenders.

- Demand curve (Lenders curve):

Shows the quantity of the asset that lenders will be willing to buy/hold at

each yield or price.

- Slope?

- at a higher yield or lower price (“other things equal”):

- generally: saving is more attractive than using the funds for consumption other purposes.

- for a specific asset: more attractive to put funds into this

asset rather than some other asset.

- demand for asset:

- higher at higher yields: so D-curve is upward sloping in yield;

- higher at lower prices: so D-curve is downward sloping

in price.

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- Some determinants of the position of the Demand curve (see Table 5-2):

Variable: Effect on Asset Demand

Level of wealth (+)

Household preferences that favor (-)present vs. future consumption

Yields on substitute assets (-)

Expected future yield on this asset (-) (via its effect on the resale price of this asset)

Riskiness vs. other assets (-) (via default risk; volatility)Liquidity vs. other assets (+)

Expected inflation (-) (if nominal yield on axis)

Yields on similar foreign assets (-)

Exchange rate expectations (expected appreciation in Cdn $ (affects returns to foreign lenders) raises Demand for Cdn. Assets)

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- The behavior underlying Demand curve is rooted in ‘portfolio demand theory’

- lenders distribute their wealth between assets by comparing the

characteristics of the assets.

- asset holders care about yield, risk and liquidity of an asset compared to the yield, risk and liquidity of other assets.

- Demand is larger the greater is wealth: bigger portfolio.

- Demand is higher if this asset has a high return compared to returns

on other assets.

- Default risk: lowers the expected return on an asseti.e. expected return is below the yield when promised

payments are made in full.

- higher default risk lower is demand.

- Risk (measured as variability of returns) is a negative attribute

assuming risk averse lenders: lowers demand.

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- Liquidity: ease with which can sell the asset at a reasonable price should you need to. A desirable attribute.

- Expected inflation: reduces the value of future payments.

- The optimal portfolio reflects all of these characteristics.

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Supply of Assets: Borrower Behavior

- Borrowers are the issuers or suppliers of the asset.

- Supply curve (Borrowers curve):- Shows the quantity of the asset that borrowers will issue at each

yield or price.

- Downward sloping in yield upward sloping in price: why?

- Price measures what borrowers get for its promise of future payments:

- higher price: better the deal for the supplier.

- Yield is a measure of the cost of funds to borrowers.

- generally: higher yield (lower price), less borrowed,

i.e., it is less likely that the use a borrower has for funds covers the cost of borrowing when yield is high.

- specific asset: higher the yield (lower the price) on a particular asset, the more likely the borrower borrows some other way.

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- Some determinants of the position of the Supply (borrowers) curve:

Variable: Effect on Asset Supply:

Yield on alternative ways of (+) borrowing

Expectations regarding future (+) business conditions

(profitability of investment projects)

Future expected household income (+)

Household preference for present (+) vs. future consumption

Government deficits (+)

Expected inflation (+) Default risk (+)

(see also Table 5-3)

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Equilibrium in the Asset Market

- Yield (i) or price (P) and quantity of the asset (B) where the lenders (Demand) and borrowers (Supply) curves intersect.

Why? Here is a bargaining story:

i too high (i>iEQ): lending (demand) > borrowing (supply)

- lenders face rationing, borrowers face excess demand for their assets.

- yield falls: borrowers are in a strong bargaining position vs. lenders.

(Could tell this in terms of asset prices: P too low (below PEQ), excess demand, price of the asset rises, so the yield falls).

i too low (i<iEQ): lending < borrowing

- borrowers face rationing, lenders face excess supply of assets.

- yield rises: lenders are in a strong bargaining position vs. borrowers.

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(Could tell this in terms of asset prices: price too high (above PEQ),

excess supply of assets, price of the asset falls, so the yield rises).Comparative Statics: why do asset prices and yields change?

- How do yields, asset prices and quantities change when factors behind the

Demand and Supply curves change?

Demand Shifts (Lender Curve Shifts):

- Anything shifting Demand right (rise in lending) gives:

- Excess demand (lending) at old asset price and yield.

- Asset price rises (yield falls) and quantity of asset rises.

i.e. new equilibrium: lower i, higher P, higher B.

- Anything shifting demand left (reduction in lending) gives:

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- Excess supply of asset (excess borrowing) at old P and i.

- Asset price falls, yield rises and quantity of asset falls.

i.e. new equilibrium: higher i, lower P, lower B. (picture: reverse shifts in picture above)

Supply Shifts (Borrower curve shifts):

- Supply shift right (more borrowing) gives:

- Excess supply at old P and i.

- Price falls, yield rises and quantity of asset higher.

i.e. new equilibrium: lower P, higher i higher B.

- Supply shift left (less borrowing) gives:

- Excess demand at old P and i.

- Price rises, yield falls and quantity of asset lower.

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i.e. new equilibrium: higher P, lower i lower B.

(diagram: reverse the supply shifts above)

Applications and Extensions:

Demographics and Interest Rates

- Household saving and borrowing patterns differ substantially by age.

- More likely to borrow when young; save for retirement in middle years.

- Changes in the age structure of the population can affect the balance of

lending and borrowing and interest rates.

e.g. baby-boom generation became concentrated in high-saving ages in

recent years: lending high, asset prices high, yields low. (Demand/lending shifts right: see above)

Government Deficits and Interest Rates: Crowding Out

- Deficit = government spending – government revenues

- deficit if spending>revenues; surplus if spending<revenues

- government borrows to cover deficit.

- Rise in government borrowing

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- borrowers curve shifts right (supply of assets rises)

- yields (interest rates) rise, asset prices fall.

(see next page)

- Crowding out problem:

- other borrowers reduce borrowing: gain from this is lost.

- may mean less investment in physical capital

- smaller capital stock

- lower future output.

(Crowding out in recessions? Likely less of a concern – private borrowing already depressed)

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US Credit Market Crunch of 2008

- Rise in the perceived default risk of “mortgage-backed securities”.

- linked to end of the US housing price boom; realization that credit ratings of

these assets were likely inaccurate.

- Rise in default risk for financial institutions thought to be exposed to these

assets.

(major question: unclear who held these “toxic” debts)

- Lenders curves (demand curves) shift left in the affected markets: rise in yields on assets these markets, fall in asset prices.

e.g. paper markets, US inter-bank markets.

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Business Cycles and Interest Rates:

- Start of a ‘Boom’:

- Businesses optimistic: many profitable opportunities, borrow to expand.

- Supply (borrowers) curves shift right- Pressure for interest rates to rise (asset price fall)

- As the ‘Boom’ develops: some complications (leading to more shifts)

- Incomes and wealth likely rising: more lending (Demand curve shifts

right).

- Inflation expectations: often rise in booms (see effect below)

- Monetary policy is often used to offset business cycles: Bank of Canada alters interest rates too.

- Governments: tax revenues high in booms (borrow less)

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Bank of Canada and Short-term Interest Rates

- Bank of Canada actions:

Open market operations (OMOs): buys or sells government financial assets.

Loans to financial institutions.

- OMOs shift the Demand and Supply curves in short-term markets and change short-term asset prices and their interest rates (yields).

- Central bank actions alter the quantity of reserve assets.

- this affects the amount of lending in loan markets (remember the ‘deposit

expansion process’)

- shifts the demand (lender) curves in loan markets.

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Fisher Effect

- Say the expected future inflation rate rises from 2% to 4%.

- Lenders (Demand for assets):

- reduce lending at current (nominal) yields

- lender curve shifts up by 2% (need an extra 2% to offset inflation if you are

to lend as much as before)

- Borrowers (Supply of Assets):

- increase borrowing at current (nominal) yields

- borrowers curve shifts up by 2% (willing to borrow as much as if the yield was 2% lower).

- Result? - equilibrium yield rises by the increase in the expected inflation

rate.

- this is the Fisher effect.

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- Other things equal, nominal interest rates move in line with changes in the

expected inflation rate.- Evidence? See Text Figure 5-5

- Casual look at the data: Canada high inflation and high interest rates in

1970s and 1980s; low rates in recent years.

- Difficulties in testing the prediction?

- measuring expected inflation

- controlling for “other things”.

- A possible indicator of expected inflation?

- Fisher effect suggests that nominal interest rates adjust for expected

inflation.

- ‘Real return bonds’ offer inflation-adjusted (real) yields.

- Difference between real return bonds and similar bonds with nominal

interest rates may measure market expectations of inflation.

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Expectations and Asset Prices and Yields

- Expectations of future changes in borrowing and lending can affect current

prices and yields now.

- Say that it is anticipated that yields on bonds will rise next period.

- lenders: - hold off on buying bonds now (buy them next period

instead)

- borrowers (bond issuers): - issue more bonds now rather than next period.

- speculators? - sell bonds now, buy bonds next period.

- These actions will tend to push up yields right away.

- Interesting implication? - current prices and yields will tend to build in current

expectations, currently known information about the future.

(see related discussion of “Efficient Markets Hypothesis” later on )

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- Simultaneous equilibria:

- Above: focus is on the market for one asset.

- But equilibrium outcome depended on variables determined in other asset

markets.

- Could allow for feedbacks between markets and determine the equilibrium

set of asset prices and yields.

- Discussion of term structure and risk structure of rates relates to this.

(next chapter and set of notes)

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