CHAPTER 4
Understanding Interest Rates
ADMINISTRATIVE DETAILS.
 Next
week we will run the interest rate
experiment from aplia.com.
 There is a homework assignment that is due
before next weeks class to prepare you for
the experiment.
 Requires bringing a laptop computer to class.
 Requires installation of the CSUN VPN on
your laptop.

http://csunecon.com/?p=63
THE IMPORTANCE OF FINANCIAL MARKETS
Financial Markets (or the ability to borrow and lend)
improves welfare in 2 ways.
 Efficiently allocates investible funds among
alternative investments.
 Provide the ability to borrow and lend money
allows people to adjust spending patterns over
time.
 Therefore, access to Financial Markets makes people
better off.

4-3
Gravina Island Bridge
projected to cost about
$500 million dollars
connecting Gravina Island
(pop. 50) to the mainland.
4-4
F-22, 28 billion to
develop.
Cost $361,000,000 dollars
per aircraft
F-35, $282,000,000,000
total program cost.
Cost $92 million per
aircraft.
MQ-9
Cost $12 million per
aircraft.
MILITARY EXPENDITURES.
Rank
1
Country
Military expenditure, 2009
% of GDP, 2008
4.30%
Greece
663,255,000,000
531,682,000,000
98,800,000,000
69,271,000,000
67,316,000,000
61,000,000,000
48,022,000,000
46,859,000,000
39,257,000,000
37,427,000,000
36,600,000,000
27,130,000,000
27,124,000,000
20,564,000,000
20,109,000,000
19,409,000,000
19,009,000,000
14,309,000,000
13,917,000,000
United Arab Emirates
13,052,000,000
Netherlands
12,642,000,000
United States
Next 10 Largest
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
China
United Kingdom
France
Russian Federation
Germany
Japan
Saudi Arabia
Italy
India
South Korea
Brazil
Canada
Australia
Spain
Turkey
Israel
U.S. military
2.00%
spending is large
2.50%
compared to GDP
2.30%
and is enormous
3.50%
compared to other
1.30%
countries.
0.90%
8.20%
1.70%
“As many frustrated Americans who have joined the Tea Party realize, we
cannot stand 2.60%
against big government at home while supporting it abroad.
2.80%
We cannot talk about fiscal responsibility while spending trillions on
1.50%
occupying and
bullying the rest of the world. We cannot talk about the budget
deficit and spiraling
1.30% domestic spending without looking at the costs of
maintaining an American empire of more than 700 military bases in more
1.80%
than 120 foreign
countries.
1.20%
We cannot pat ourselves on the back for cutting a few thousand dollars from a
2.20%
nature preserve
or an inner-city swimming pool at home while turning a blind
eye to a Pentagon
7.00%budget that nearly equals those of the rest of the world
combined.”
3.60%
Ron Paul
5.9%
1.40%
The views from atop Los Angeles Unified School District's
downtown headquarters are sweeping: Disney Hall, the Music
Center complex, iconic high-rise buildings that make up the
L.A. skyline.
Inside the 29-story building, more than 3,400 employees filter
through LAUSD's main offices every week. The triangular,
928,000-square-foot tower at 333 S. Beaudry Ave. had
historically been difficult to lease while owned by Bank of
America. It was purchased and renovated by LAUSD in 2001
for $154 million.
But even today, according to a top LAUSD official, the
building seems too ostentatious in light of budget cuts and
other financial issues the country's second-largest public school
district is grappling with.
But Superintendent David Brewer III maintained that Beaudry
should not be viewed as a typical corporate building, saying it
lacks the granite, fine wood and other trappings of some of
downtown's more grandiose skyscrapers.
"It's pretty austere," Brewer said, adding that his own offices
are adequate.
He said that while $154 million might seem pricey for the
purchase and rehabilitation of the building, it is far less than the
cost of leasing space downtown for all of the district's
administrators and support staff. Brewer said he hopes the
building eventually will come to be seen as a symbol of
efficiency as he reduces the size of the central administration
and consolidates leased space at other downtown locations into
Beaudry.
"It will be a symbol of success versus a symbol of bureaucracy.
We'll consolidate all in one and save a fortune, and that's the
ultimate in decentralization
.
EFFICIENT ALLOCATION OF INVESTIBLE FUNDS
Potential Projects
2
3
1
Interest Rate
20%
4
5
6
Expected Rate of
Return
20%
15%
10%
5%
2%
1%
Required
Investment (billions
of dollars)
20
10
15
8
5
10
15%
Suppose there are 6 potential projects
that could be funded and the expected
rates of return and required
investments are given in the table
above.
10%
If there was a pool of 53 billion dollars
of investible funds, what is an efficient
allocation of funds among the
potential projects, i.e. what allocation
will maximize social welfare.
5%
2%
Demand
(borrowers)
1%
20
30
45
53
58
68
Billions of dollars
Proposed 1.2 billion dollar 72,000
seat NFL stadium next to the
convention center.
Supported by 350 million dollars
of government bonds to finance
construction with AEG promising
to repay the bonds with revenue
from the stadium.
4-9
3808 Woolwine Dr, Los Angeles.
2145 sq. ft. house built in 1932.
Was worth approximately $600K
in 2006.
Repossessed in Nov. 2010 with a
mortgage of $298,199.
Sold in Feb. 2011 for 170,000.
On the market Sept. 2011, now for
$338K.
4-10
Proposed Keystone Pipeline.
Estimated cost 13 billion dollars.
4-11
Obama
Officials
Defend
Solar
Loan in
to May
Bankrupt
Firm as Emails
Show Past
President
Obama
visited
Solyndra
2010, heralding
the company
Concerns
as “leading the way toward a brighter and more prosperous future.” He
also cited it as a success story from the government’s $787 billion
Obama
administration
economic
stimulus officials
package.on Wednesday defended a $528 million loan to a solarpanel company that went bankrupt this month, claiming the firm fell victim to global
economic
trends
but that
investment
energy
must continue.
“Less than
a year
ago,federal
we were
standing in
onalternative
what was an
empty
lot. But through the Recovery Act, this company received a loan to
Theexpand
testimony
came as Republican
and at
Democratic
lawmakers
raised sharp
questions
its operations,”
Obama said
the time. “This
new factory
is
about
decision
thatloans.”
ultimately left taxpayers on the hook for millions, and as newly
thethe
result
of those
released emails show administration officials were raising doubts about the loan
proposal to Solyndra months before it was finalized.
In 2009, the Obama administration fast-tracked Solyndra’s loan
application, later awarding it $535 million in guarantees from the
But stimulus
emails released
funds. by the House Energy and Commerce Committee show that the
relevant credit committee decided "not to engage in further discussions with Solyndra"
in the
final
the Bush
the change
in administration, officials
The
dealdays
laterofcame
underadministration.
scrutiny from After
independent
government
restarted
loan
review
process
for Solyndra.
watchthe
dogs
and
members
of Congress,
which said the administration
had bypassed key taxpayer protections in a rush to approve the funds
One—
Republican
said the emails
released as part of that probe show the White House
claims theaide
administration
has denied.
was more concerned with press events surrounding the loan than the soundness of
Solyndra. The aide said "corners were cut."
The emails at least show budget analysts felt rushed by the White House to review the
loan guarantee in time for an announcement by Vice President Biden in September
2009.
The concerns flared in August 2009, when staff with the Energy Department wrote of a
"major outstanding issue," relating to the project's solvency. They noted an estimate said
the project would run out of cash in September 2011.
But other administration officials presumed the parent company, as well as private
investors, would cushion the project and ensure its completion.
The company filed for bankruptcy this month.
4-12
EFFICIENT ALLOCATION OF INVESTIBLE FUNDS
Interest Rate
1
20%
Potential Projects
2
3
4
5
6
Expected Rate of
Return
20%
15%
10%
5%
2%
1%
Required
Investment (billions
of dollars)
20
10
15
8
5
10
15%
The efficient allocation, i.e. the allocation that
would maximize social welfare, would be to
Supply fund the projects with the highest rate or
return and leave the ones with lower (or
negative) rates of return unfunded.
10%
In a free or unregulated market, this is exactly
the allocation that would occur because people
investing their own money would seek out the
projects with the highest returns.
5%
Adding uncertainty into the mix would not
change this result.
2%
Demand
1%
20
30
45
53
58
68
Billions of dollars
EFFICIENT ALLOCATION OF INVESTIBLE FUNDS
Interest Rate
1
20%
Potential Projects
2
3
4
5
6
Expected Rate of
Return
20%
15%
10%
5%
2%
1%
Required
Investment (billions
of dollars)
20
10
15
8
5
10
15%
Supply
10%
Suppose a different allocation occurred,
possibly due to government intervention that
directed loanable funds to projects that
would not be funded in a free unregulated
market.
What effect would this have on social
welfare?
For instance, suppose money was taken from
project 2 and diverted to project 6?
5%
Net loss of 14%*10 billion = $1.4 billion.
2%
Demand
1%
20
30
45
53
58
68
Billions of dollars
FREE MARKETS AND EFFICIENT ALLOCATIONS




Generally speaking, loanable funds will be allocated efficiently if
decisions are left in the hands of those who will be rewarded
financially if funds are allocated correctly and penalized
financially if funds are incorrectly allocated.
This does not mean that every investment funded by private
investors will be profitable or able to repay money borrowed
because no one can foresee the future.
Private investors will make mistakes but when they do, they
alone will suffer the consequences.
Gross misallocation of loanable funds generally occur when the
person making the decision about whom to lend to is not
rewarded for choosing wisely and not punished for choosing
poorly.
4-15
EXAMPLES OF MISALLOCATION OF LOANABLE FUNDS
REDUCING SOCIAL WELFARE.



Spanish promotion of green energy.
 http://www.juandemariana.org/pdf/090327-employment-public-aidrenewable.pdf
 Spent $774,000 for each “green job” created.
 Destroyed 2.2 jobs for each “green job” created.
 Increased the price of electricity costing consumer and driving businesses
that are heavy electricity users to other countries.
Chinese promotion of green energy.
 http://www.nytimes.com/2010/09/09/business/global/09trade.html
In both cases, if producing electricity using wind or the sun was the lowest cost
method of producing power, no government subsidy would be necessary to
“promote” the industry.
 If a solar panel costs $100,000 to produce and produces a flow of electricity
worth $50,000 over its life, subsidizing its production reduces social
welfare.
 If a solar panel costs $100,000 to produce and produces a flow of electricity
worth $200,000 over its life, no subsidy is necessary.
 The main beneficiary of the subsidies are purchasing countries like the
4-16
U.S.
EXAMPLES OF MISALLOCATION OF LOANABLE FUNDS
REDUCING SOCIAL WELFARE.



Municipal Finance of Sports Stadiums.
http://online.wsj.com/article/SB10001424052748704269204575
270802154485456.html
 History of government financing public sports stadiums is
that the debt eventually has to be repaid with general tax
revenue rather than revenue from the stadium.
 If the stadium offered and expected return above the
market rate of interest, no public financing would be
necessary.
Explanations for the interference in the market:



Stupidity.
Corruption.
Redistribution of Income.
4-17
EFFICIENT ALLOCATION OF INVESTIBLE FUNDS
Interest Rate
1
20%
Potential Projects
2
3
4
5
6
Expected Rate of
Return
20%
15%
10%
5%
2%
1%
Required
Investment (billions
of dollars)
20
10
15
8
5
10
15%
Supply
10%
Any interference in the allocation of
funds that occurs in an unregulated
market reduces social welfare.
And redistributes income from one
group to another group.
5%
2%
Demand
1%
20
30
45
53
58
68
Billions of dollars
Consumption in the future
THE INTER TEMPORAL BUDGET CONSTRAINT
If the person engaged in
zero consumption today,
how much consumption
could he have in the
future?
Use Budget line and IC analysis to show how access to
financial markets makes people better off by allowing
them to control when and how much they consume over
time.
If a person borrowed
$10K today at 10%
interest he would owe
$11K in the future.
Starting point
without financial
markets.
$50K
Consider a person who will make $50,000
today and $50,000 in the future. What does his
budget line look like if the interest rate is
10%?
What are the endpoints of the budget line
and what behavior do the represent?
Suppose a
person wanted
to consume
$60K today.
If the person engaged in
zero consumption in the
future, how much
consumption could he
engage in today?
$39K
$50K
$60K
Consumption today
Consumption tomorrow
Future Value = 50,000 (1.1) +
50,000= $105,000
The inter temporal budget constraint shows
combinations of consumption now and in the
future that are attainable with a certain flow of
income and access to financial markets, i.e. the
ability to borrow and lend money at the current
interest rate.
The present value of the person’s income
stream is the horizontal intercept, i.e. what is
the maximum amount of consumption the
person given his stream of income and access
to financial markets, i.e. the ability to borrow
and/or lend at market interest rate.
$105K
Starting point
without financial
markets.
$50K
$50K
The future value of a person’s income stream is
the vertical intercept, i.e. what is the maximum
amount of consumption he could engage in
given his stream of income and access to
financial markets.
Present Value =50,000/(1.1)+ 50,000=
45454.54+ 50,000=
95,454.54
Consumption today
$95,454.54
Consumption tomorrow
If he tried to lend money could
he spend more or less in the
future if the interest rate is
higher?
Suppose interest rates increase to 20%.
How would this affect the inter temporal
budget constraint and the present and
future value of his income stream?
50,000 +(50,000)(1.2)=110,000
$105K
Starting point
without financial
markets.
$50K
If tried to borrow money could
he borrow more or less if the
interest rate is higher?
50,000 +(50,000)/(1.2)=91,666.67
$50K
Consumption today
$95,454.54
The Bond Market and Direct Finance.
Consumption tomorrow
Discount Bond
A Discount Bond is piece of paper
promising to pay a certain amount of
money at a certain future date.
I will pay you $10 in
the future.
If a person sells a discount bond he is
borrowing money.
If a person buys a discount bond .
Spend $400 on
bonds today
and receives
$500 in the
future.
$50,500
$50K
Suppose this person bought 50 discount
bonds for $8 each.
What is the interest rate?
25%
Where on the inter temporal budget
constraint will he be?
$50K
$49,600
Consumption today
What will the intertemporal budget constraint
look like if the person earns 50K today and
expects to earn 50K in the future?
Consumption tomorrow
Future Value = 50,000 (1.1) +
50,000= $105,000
New budget constraint
Suppose policy makers could convince this
person that his income in the future would be
75K in the future.
What effect would this have on his intertemporal budget constraint?
$105K
Starting point without financial markets where
current income is $50K and future income is $75K
$75K
Starting point
without financial
markets.
$50K
$50K
Present Value =50,000/(1.1)+ 50,000=
45454.54+ 50,000=
95,454.54
Consumption today
$95,454.54
Indifference Curves
Good A
Any combination of 2
goods on IC2 is
preferred over any
combination on IC3.
Bundle Y is preferred
over Bundle X
because Y has the
same amount of good
B and more good A
Indifference curves capture a person ‘s
tastes and preferences, i.e. how much
relative enjoyment he gets from
consuming different goods.
Any particular indifference curve shows
combinations of two goods that give the
person equal utility or, stated
alternatively combinations of two goods
that a person doesn’t care which he
receives.
Y
Comparing indifference curves, the
person is always happier if he could
move to a consumption bundle that is on
a higher IC, i.e. farther out from the
origin.
IC2
X
IC1
Any combination of 2
goods on IC1 give
equal levels of utility.
Good B
Indifference Curves
Income
How would you describe the movement
How
would
from
X to
Y? you describe the movement
from X to Y?
Nissan Cube, $15,000
Honda Fit, $17,000
X
Y
Which point is the Cube and which is the
Fit?
IC2
IC1
Automobiles
Indifference Curves and Equilibrium
Income
The person chooses the point on the
inter-temporal budget constraint which is
on the highest indifference curve.
Y is preferred to X because IC2 is farther
out from the origin than IC1.
X
Y
IC2
IC1
Automobiles
Indifference Curves and Equilibrium
Consider the indifference curves of two
people who both make 50K today and
expect to make 50K in the future whose
IC’s are depicted below.
Consumption tomorrow
Which person is going to be a net
borrower today and which person will be
a net saver today?
$105K
Blue will be a borrower and red will be a
saver.
Starting point.
Moving from the starting point to
here, is the person a net borrower
or net lender?
$50K
Will he buy or sell bonds?
$50K
Consumption today
$95,454.54
How will a decrease in current interest rates affect current
consumption and net borrowing and lending or stated
alternatively, if the Federal Reserve followed a monetary
policy which lowered interest rates how would this affect an
ongoing recession?
Consumption tomorrow
$105K
The decrease in the interest rate will cause the inter temporal
budget constraint to rotate.
The present value of his income will increase.
He will consume more now and less in the future.
What effect will a reduction in interest rates have on a
recession?
Starting point.
$50K
$50K
$95,454.54
Consumption today
Consumption tomorrow
New budget constraint
where the person
expects to earn more in
the future
Consider an economic policy which simply
changes people’s expectations about the future.
Suppose policy makers could convince this
person that his income in the future would be
75K in the future.
What effect would this have on his intertemporal budget constraint?
$105K
New equilibrium
$75K
$50K
Starting point where the person
earns and consumes 50K today
and 50K in the future.
$50K
Consumption today
Consumption tomorrow
New budget constraint
where the person
expects to earn more in
the future
Consider an economic policy which simply
changes people’s expectations about the future.
What effect would this have on current
consumption and current demand for goods and
services?
What effect would this have on the bond
market, i.e. would the amount of net borrowing
increase?
$105K
Would interest rates rise or fall?
$75K
New equilibrium
$50K
Starting point where the person
earns and consumes 50K today
and 50K in the future.
People would increase current consumption by
borrowing against the future income.
This would increase the supply of bonds, lowering
their price and increasing interest rates.
$50K
Consumption today
Consider an economic policy which made
people expect less income in the future.
Consumption tomorrow
$105K
$75K
$50K
Starting point where the person
earns and consumes 50K today
and 50K in the future.
$50K
Consumption today
REAL AND NOMINAL INTEREST RATES




Nominal interest rate makes no allowance for
inflation
Real interest rate is adjusted for changes in price
level so it more accurately reflects the cost of
borrowing
Ex ante real interest rate is adjusted for expected
changes in the price level
Ex post real interest rate is adjusted for actual
changes in the price level
FISHER EQUATION
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
FIGURE 1 REAL AND NOMINAL INTEREST RATES
(THREE-MONTH TREASURY BILL), 1953–2008
What does it tell you about
inflation that the nominal
rate is above the real rate.?
Sources: Nominal rates from www.federalreserve.gov/releases/H15. The real rate is constructed using the procedure
outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference
Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function of past
interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal
interest rate.
CHAPTER 5
The Behavior of Interest Rates
2 MODELS USED TO PREDICT AND
UNDERSTAND CHANGES IN INTEREST RATES
• Basic supply and demand
analysis in the bond
market.
• Liquidity Preference Model
(Keynesian)
UNDERSTANDING WHAT CAUSES CHANGES IN
INTEREST RATES.
If the price of a discount




Use basic supply and demand
analysis in the bond market.
bond with a face value of
$1000 is $1000 then the
interest rate is zero
Assume that there is only one type
of bond—a simple discount bond
with a face value of $1000.
The price of bonds determines the
interest rate and the bond price is
inversely related to interest rate.
What happens when bond prices
are below the equilibrium price.
For any one year discount bond
F-P
P
F = Face value of the discount bond
i=
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
If the price of a discount
bond with a face value of
$1000 is $800 then $800
is being lent, $200
interest is being paid and
the interest rate is 25%
UNDERSTANDING WHAT CAUSES CHANGES
IN INTEREST RATES.
•
Suppose the demand for
bonds increases?
•
Is this due to more people
wanting to lend or borrow?
•
•
At the current price ($850)
is there excess demand or
excess supply?
•
•
•
Lend.
Excess demand.
What will happen to the
price and quantity of
bonds sold?
•
More bonds sold.
•
Higher price.
What happens to interest
rates?
•
Interest rates fall.
UNDERSTANDING WHAT CAUSES CHANGES
IN INTEREST RATES.
•
Suppose the supply for
bonds increases?
•
Is this due to more people
wanting to lend or borrow.
•
•
At the current price ($850)
is there excess demand or
excess supply?
•
•
•
Borrow
Excess supply.
What will happen to the
price and quantity of
bonds sold?
•
More bonds sold.
•
lower price.
What happens to interest
rates?
•
Interest rates rise.
DETERMINING THE QUANTITY DEMANDED OF
AN ASSET


Analysis of changes in interest rates using The Supply and
Demand for bonds requires identifying what causes shifts in
the supply and demand curves and doing simple supply and
demand analysis.
List of factors that can affect the demand for bonds.

Wealth: the total resources owned by the individual, including all assets

Expected Return: the return expected over the next period on one asset
relative to alternative assets

Risk: the degree of uncertainty associated with the return on one asset
relative to alternative assets

Liquidity: the ease and speed with which an asset can be turned into cash
relative to alternative assets
THEORY OF ASSET (BOND) DEMAND
Holding all other factors constant:
1.
The quantity demanded of an asset is positively related
to wealth
2.
The quantity demanded of an asset is positively related
to its expected return relative to alternative assets
3.
The quantity demanded of an asset is negatively related
to the risk of its returns relative to alternative assets
4.
The quantity demanded of an asset is positively related
to its liquidity relative to alternative assets
SUMMARY TABLE 1 RESPONSE OF THE QUANTITY OF AN
ASSET DEMANDED TO CHANGES IN WEALTH, EXPECTED
RETURNS, RISK, AND LIQUIDITY
SUPPLY AND DEMAND FOR BONDS
• At lower prices (higher
interest rates), ceteris
paribus, the quantity
demanded of bonds is
higher: an inverse
relationship
• At lower prices (higher
interest rates), ceteris
paribus, the quantity
supplied of bonds is
lower: a positive
relationship
MARKET EQUILIBRIUM
 Occurs
when the amount that people are
willing to buy (demand) equals the amount
that people are willing to sell (supply) at a
given price
 Bd
= Bs defines the equilibrium (or market
clearing) price and interest rate.
 When
Bd > Bs , there is excess demand, price
will rise and interest rate will fall
 When
Bd < Bs , there is excess supply, price
will fall and interest rate will rise
SHIFTS IN THE DEMAND FOR BONDS





Wealth: in an expansion with growing wealth, the
demand curve for bonds shifts to the right
Expected Returns: higher expected interest rates in
the future lower the expected return for long-term
bonds, shifting the demand curve to the left
Expected Inflation: an increase in the expected rate of
inflations lowers the expected return for bonds,
causing the demand curve to shift to the left
Risk: an increase in the riskiness of bonds causes the
demand curve to shift to the left
Liquidity: increased liquidity of bonds results in the
demand curve shifting right
SUMMARY TABLE 2 FACTORS THAT SHIFT
THE DEMAND CURVE FOR BONDS
FIGURE 2 SHIFT IN THE DEMAND
CURVE FOR BONDS
SHIFTS IN THE SUPPLY OF BONDS



Expected profitability of investment opportunities:
in an expansion, the supply curve shifts to the right
Expected inflation: an increase in expected inflation
shifts the supply curve for bonds to the right because
the expected real rate of interest declines.
Government budget: increased budget deficits shift
the supply curve to the right
SUMMARY TABLE 3 FACTORS THAT SHIFT
THE SUPPLY OF BONDS
FIGURE 3 SHIFT IN THE SUPPLY CURVE
FOR BONDS
FIGURE 4 RESPONSE TO A CHANGE IN
EXPECTED INFLATION
When expected
inflation rises,
the real cost of
borrowing falls
leading to an
increase in the
supply of bonds
The decrease in
the price of
bonds leads to
an increase in
the nominal rate
of interest paid
on bonds.
When expected
inflation rises,
the expected
return to holding
bonds decrease
leading to a
decrease in the
demand for
bonds
FIGURE 7 BUSINESS CYCLE AND INTEREST RATES
(THREE-MONTH TREASURY BILLS), 1951–2008
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
FIGURE 6 RESPONSE TO A BUSINESS
CYCLE EXPANSION
If supply
increases more
than demand,
the price of
bonds falls and
interest rates
rise.
During a
business cycle
expansion, the
increase in
business
opportunities
leads to an
increase in the
supply of bonds
During a
business cycle
expansion, the
increase in
income and
wealth causes
an increase in
the demand for
bonds.
FIGURE 5 EXPECTED INFLATION AND INTEREST RATES
does it
(THREE-MONTH TREASURY BILLS), 1953–2008 What
mean if the
expected rate of
inflation is
above the
nominal interest
rate?
Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest
Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200.
These procedures involve estimating expected inflation as a function of past interest rates, inflation, and
time trends.
SAMPLE EXAM QUESTION



Read the attached article about the Euro and the Greek debt crisis. Consider the effect on
the price and interest rate of risk free bonds issued by the U.S. government. Use both the
Supply and Demand for bonds and the Liquidity Preference Framework to analyze the
effect of a possible Greek default on U.S. interest rates. Compare and contrast your
analyses.
Discuss and show the effects on the demand for U.S. government bonds and the risk free
rate of interest using the graph on the left.
 Identify each factor which will cause the demand curve to shift and plot the
corresponding shift on the graph below. Factors to consider include changes in wealth,
expected returns, expected inflation, risk and liquidity.
 Identify each factor which will cause the supply curve to shift and plot the
corresponding shift on your graph. Factors to consider include expected profitability of
investment opportunities, expected inflation, and government budget deficits.
Discuss and show the effects on the demand for money in the U.S. using the Liquidity
Preference Framework on the right hand graph.
 Identify each factor which will cause the demand for money to shift. Factors to
consider include income effects, price level effects, and expected inflation.
 What does the Liquidity Preference Framework predict will happen to interest rates?
A bail-out for Greece is just the beginning
By Martin Wolf
Published: May 4 2010 20:13 | Last updated: May 4 2010 20:13
Desperate times; desperate measures. After months of costly delay, the eurozone has come up with an enormous package of support for
Greece. By bringing in the International Monetary Fund, at Germany’s behest, it has obtained some additional resources and a better
programme. But is it going to work? Alas, I have huge doubts.
So what is the programme? In outline, it is a package of €110bn (equivalent to slightly more than a third of Greece’s outstanding debt),
€30bn of which will come from the IMF (far more than normally permitted) and the rest from the eurozone. This would be enough to
take Greece out of the market, if necessary, for more than two years. In return, Greece has promised a fiscal consolidation of 11 per
cent of gross domestic product over three years, on top of the measures taken earlier, with the aim of reaching a 3 per cent deficit by
2014, down from 13.6 per cent in 2009. Government spending measures are to yield savings of 5¼ per cent of GDP over three years:
pensions and wages will be reduced, and then frozen for three years, with payment of seasonal bonuses abolished. Tax measures are to
yield 4 per cent of GDP. Even so, public debt is forecast to peak at 150 per cent of GDP.
In important respects, the programme is far less unrealistic than its intra-European predecessor. Gone is the fantasy that there would be
a mild economic contraction this year, followed by a return to steady growth. The new programme apparently envisages a cumulative
decline in GDP of about 8 per cent, though such forecasts are, of course, highly uncertain. Similarly, the old plan was founded on the
assumption that Greece could slash its budget deficit to less than 3 per cent of GDP by the end of 2012. The new plan sets 2014 as the
target year.
Have your say on Martin Wolf’s column and read contributions by leading economists
Two other features of what has been decided are noteworthy: first, there is to be no debt restructuring; and, second, the European
Central Bank will suspend the minimum credit rating required for the Greek government-backed assets used in its liquidity operations,
thereby offering a lifeline to vulnerable Greek banks.
So does this programme look sensible, either for Greece or the eurozone? Yes and no in both cases.
Let us start with Greece. It has now lost access to the markets (see chart). Thus, the alternative to agreeing to this package (whether or
not it can be implemented) would be default. The country would then no longer pay debt interest, but it would have to close its primary
fiscal deficit (the deficit before interest payments), of 9-10 per cent of GDP, at once. This would be a far more brutal tightening than
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Greece has now agreed. Moreover, with default, the banking system would collapse. Greece is right to promise the moon, to gain the
time to eliminate its primary deficit more smoothly.
Yet it is hard to believe that Greece can avoid debt restructuring. First, assume, for the moment, that all goes to plan. Assume, too, that
Greece’s average interest on long-term debt turns out to be as low as 5 per cent. The country must then run a primary surplus of 4.5
per cent of GDP, with revenue equal to 7.5 per cent of GDP devoted to interest payments. Will the Greek public bear that burden year
after weary year? Second, even the IMF’s new forecasts look optimistic to me. Given the huge fiscal retrenchment now planned and
the absence of exchange rate or monetary policy offsets, Greece is likely to find itself in a prolonged slump. Would structural reform
do the trick? Not unless it delivers a huge fall in nominal unit labour costs, since Greece will need a prolonged surge in net exports to
offset the fiscal tightening. The alternative would be a huge expansion in the financial deficit of the Greek private sector. That seems
inconceivable. Moreover, if nominal wages did fall, the debt burden would become worse than forecast.
Willem Buiter, now chief economist at Citigroup, notes, in a fascinating new paper, that other high-income countries, notably Canada
(1994-98), Sweden (1993-98) and New Zealand (1990-94), have succeeded with fiscal consolidation. But initial conditions were much
more favourable in these cases. Greece is being asked to do what Latin America did in the 1980s. That led to a lost decade, the
beneficiaries being foreign creditors. Moreover, as creditors are now paid to escape, who will replace them? This package will surely
fail to return Greece to the market, on manageable terms, in a few years. More money will be needed if debt restructuring is unwisely
ruled out.
For other eurozone members, the programme prevents an immediate shock to fragile financial systems: it is overtly a rescue of
Greece, but covertly a bail-out of banks. But it is far from clear that it will help other members now in the firing line. Investors could
well conclude that the scale of the package required for tiny Greece and the overwhelming difficulty of agreeing and ratifying it,
particularly in Germany, suggest that further such packages are going to be elusive. Other eurozone members might well end up on
their own. None is in as bad a condition as Greece and none has shown the same malfeasance. But several have unsustainable fiscal
deficits and rapidly rising debt ratios (see chart). In this, their situation does not differ from that of the UK and US. But they lack the
same policy options.
This story, in short, is not over.
For the eurozone, two lessons are clear: first, it has a clear choice – either it allows sovereign defaults, however messy, or it creates a
true fiscal union, with strong discipline and funds sufficient to cushion adjustment in crushed economies – Mr Buiter recommends a
European Monetary Fund of €2,000bn; and, second, adjustment in the eurozone is not going to work without offsetting adjustments in
core countries. If the eurozone is willing to live with close to stagnant overall demand, it will become an arena for beggar-myneighbour competitive disinflation, with growing reliance on world markets as a vent for surplus. Few are going to like this outcome.
The crises now unfolding confirm the wisdom of those who saw the euro as a highly risky venture. These shocks are not that
surprising. On the contrary, they could have been expected. The fear that yoking together such diverse countries would increase
tension, rather than reduce it, also appears vindicated: look at the surge of anti-European sentiment inside Germany. Yet, now that the
eurozone has been created, it must work. The attempted rescue of Greece is just the beginning of the story. Much more still needs to
be done, in responding to the immediate crisis and in reforming the eurozone itself, in the not too distant future. [email protected]
Bond Market (Demand)
1. Risk: increased of Greek bonds increases
demand for U.S. govt. bonds.
2. Liquidity: reduced liquidity of Greek bonds
increases relative liquidity of and demand for
U.S. bonds.
3. Wealth and Expected Inflation : unclear.
Bond Market (Supply)
1. Expected Profitability of Investments: fewer
investment possibilities reduces supply of
bonds.
2. Expected Inflation: unclear
3. Budget Deficits: unclear
Demand for Money (U.S)
1. Income Effect: uncertain
2. Price Level Effect: uncertain
3. Expected Inflation Effect: uncertain
THE LIQUIDITY PREFERENCE FRAMEWORK
Keynesian model that determines the equilibrium interest rate
in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs  M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).
FIGURE 8 EQUILIBRIUM IN THE MARKET
FOR MONEY
Money Supply
is depicted as a
vertical line
because it is
controlled by
the Fed.
DEMAND FOR MONEY IN THE LIQUIDITY
PREFERENCE FRAMEWORK

Why is the demand for money downward sloping?

As the interest rate increases:
The opportunity cost of holding money increases…
 The relative expected return of money decreases…

…and therefore the quantity demanded of money
decreases.
 The higher the rate of interest the less money you will
demand because by holding money you forego interest.

4-63
Problems
faced by
organized
crime.
Why the
mafia liked
vending
machines
and casinos.
4-64
SHIFTS IN THE DEMAND FOR MONEY


Income Effect: a higher level of income causes the
demand for money at each interest rate to increase
and the demand curve to shift to the right
Price-Level Effect: a rise in the price level causes the
demand for money at each interest rate to increase
and the demand curve to shift to the right
SHIFTS IN THE SUPPLY OF MONEY


Assume that the supply of money is controlled by
the central bank
An increase in the money supply engineered by the
Federal Reserve will shift the supply curve for
money to the right
FIGURE 9 RESPONSE TO A CHANGE IN
INCOME OR THE PRICE LEVEL
An increase in
the price level
or an increase
in income will
cause an
increase in
interest rates
everything else
equal.
FIGURE 10 RESPONSE TO A CHANGE IN
THE MONEY SUPPLY
An increase in
the money
supply will
cause a
decrease in
interest rates
everything else
equal.
SUMMARY TABLE 4 FACTORS THAT SHIFT
THE DEMAND FOR AND SUPPLY OF MONEY
EVERYTHING ELSE REMAINING EQUAL?

Liquidity preference framework leads to the conclusion
that an increase in the money supply will lower interest
rates------but the liquidity effect and an increase in the
price level causes counteracting effects.

Income effect finds interest rates rising because increasing the
money supply is an expansionary influence on the economy (the
demand curve shifts to the right).

Price-Level effect predicts an increase in the money supply leads
to a rise in interest rates in response to the rise in the price level
(the demand curve shifts to the right).

Expected-Inflation effect shows an increase in interest rates
because an increase in the money supply may lead people to
expect a higher price level in the future (the demand curve shifts
to the right).
FIGURE 10 RESPONSE TO A CHANGE IN
THE MONEY SUPPLY
Whether an
increase in the
money supply will
increase or
decrease the
interest rate
depends on the
relative strength of
the counteracting
forces, i.e. income
effect, price level
effect, and
expected inflation
effect.
PRICE-LEVEL EFFECT
AND EXPECTED-INFLATION EFFECT

A one time increase in the money supply will initiate a chain of
events that will effect interest rates over time as the relative
strength of two effects changes.

A one time increase in the money supply will cause prices to rise to a
permanently higher level by the end of the year. The interest rate will rise
via the increased prices.

Price-level effect remains even after prices have stopped rising.

A rising price level will raise interest rates because people will expect
inflation to be higher over the course of the year. When the price level stops
rising, expectations of inflation will return to zero.

Expected-inflation effect persists only as long as the price level continues to
rise.
FIGURE 10 RESPONSE TO A CHANGE IN
THE MONEY SUPPLY
Wealth/Liquidity
Effect
Temporary Expected
Inflation Effect
FIGURE 11 RESPONSE OVER TIME TO AN
INCREASE IN MONEY SUPPLY GROWTH
FIGURE 12 MONEY GROWTH (M2, ANNUAL RATE) AND
INTEREST RATES (THREE-MONTH TREASURY BILLS),
1950–2008
Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
EXAM QUESTION FROM SPRING 2010.




Consider the two economic models used to explain interest rates from the textbook- the
Liquidity Preference Framework and the Theory of Asset Demand. Explain and label all
changes on your graph.
Use the graphs below and compare and contrast predictions about the change in interest
rates from both models if the government increased the money supply.
Consider Part (3) from question 1. Use the graphs below and analyze the effects on
interest rates from the change in expectations about future employment prospects on
current interest rates.
In your opinion, which framework offers more insight into the determination of future
interest rates. Explain.
Interest Rate
Price of Bonds
Quantity of Bond
Quantity of Money
CHAPTER 6
The Risk and Term Structure
of Interest Rates
FIGURE 1 LONG-TERM BOND YIELDS,
1919–2008
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve: www.federalreserve.gov/releases/h15/data.htm.
RISK STRUCTURE OF INTEREST RATES

Bonds with the same maturity have different
interest rates due to:
Default risk
 Liquidity
 Tax considerations

RISK STRUCTURE OF INTEREST RATES

Default risk: probability that the issuer of the bond is
unable or unwilling to make interest payments or pay off
the face value

U.S. Treasury bonds are considered default free (government
can raise taxes).

Risk premium: the spread between the interest rates on bonds
with default risk and the interest rates on (same maturity)
Treasury bonds
FIGURE 2 RESPONSE TO AN INCREASE
IN DEFAULT RISK ON CORPORATE BONDS
TABLE 1 BOND RATINGS BY MOODY’S,
STANDARD AND POOR’S, AND FITCH
RISK STRUCTURE OF INTEREST RATES


Liquidity: the relative ease with which an asset can
be converted into cash

Cost of selling a bond

Number of buyers/sellers in a bond market
Income tax considerations

Interest payments on municipal bonds are exempt from
federal income taxes.
FIGURE 3 INTEREST RATES ON
MUNICIPAL AND TREASURY BONDS
TERM STRUCTURE OF INTEREST RATES

Bonds with identical risk, liquidity, and tax
characteristics may have different interest rates
because the time remaining to maturity is different
TERM STRUCTURE OF INTEREST RATES

Yield curve: a plot of the yield on bonds with
differing terms to maturity but the same risk,
liquidity and tax considerations

Upward-sloping: long-term rates are above
short-term rates

Flat: short- and long-term rates are the same

Inverted: long-term rates are below short-term rates
FACTS THEORY OF THE TERM STRUCTURE OF
INTEREST RATES MUST EXPLAIN
1.
Interest rates on bonds of different maturities move
together over time
2.
When short-term interest rates are low, yield curves
are more likely to have an upward slope; when shortterm rates are high, yield curves are more likely to
slope downward and be inverted
3.
Yield curves almost always slope upward
THREE THEORIES TO EXPLAIN THE THREE
FACTS
1.
Expectations theory explains the first two facts
but not the third
2.
Segmented markets theory explains fact three but
not the first two
3.
Liquidity premium theory combines the two
theories to explain all three facts
FIGURE 4 MOVEMENTS OVER TIME OF INTEREST RATES
ON U.S. GOVERNMENT BONDS WITH DIFFERENT
MATURITIES
Sources: Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.
EXPECTATIONS THEORY
The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond
 Buyers of bonds do not prefer bonds of one maturity over
another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different
maturity
 Bond holders consider bonds with different maturities to
be perfect substitutes

EXPECTATIONS THEORY: EXAMPLE




Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be
8% next year.
Then the expected return for buying two one-year
bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for
you to be willing to purchase it.
EXPECTATIONS THEORY
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
EXPECTATIONS THEORY (CONT’D)
Expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
EXPECTATIONS THEORY (CONT’D)
If two one-period bonds are bought with the $1 investment
(1  it )(1  i )  1
e
t 1
1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1
EXPECTATIONS THEORY (CONT’D)
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
int 
it  ite1  ite 2  ...  ite ( n 1)
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
EXPECTATIONS THEORY




Explains why the term structure of interest rates
changes at different times
Explains why interest rates on bonds with different
maturities move together over time (fact 1)
Explains why yield curves tend to slope up when shortterm rates are low and slope down when short-term
rates are high (fact 2)
Cannot explain why yield curves usually slope upward
(fact 3)
SEGMENTED MARKETS THEORY




Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different
maturity is determined by the demand for and supply of
that bond
Investors have preferences for bonds of one maturity
over another
If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then this
explains why yield curves usually slope upward (fact 3)
LIQUIDITY PREMIUM &
PREFERRED HABITAT THEORIES


The interest rate on a long-term bond will equal an
average of short-term interest rates expected to
occur over the life of the long-term bond plus a
liquidity premium that responds to supply and
demand conditions for that bond
Bonds of different maturities are partial (not
perfect) substitutes
LIQUIDITY PREMIUM THEORY
int 
e
e
e
it  it1
 it2
 ... it(
n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
PREFERRED HABITAT THEORY



Investors have a preference for bonds of one
maturity over another
They will be willing to buy bonds of different
maturities only if they earn a somewhat higher
expected return
Investors are likely to prefer short-term bonds over
longer-term bonds
FIGURE 5 THE RELATIONSHIP BETWEEN THE
LIQUIDITY PREMIUM (PREFERRED HABITAT) AND
EXPECTATIONS THEORY
LIQUIDITY PREMIUM AND PREFERRED HABITAT
THEORIES



Interest rates on different maturity bonds move
together over time; explained by the first term in
the equation
Yield curves tend to slope upward when short-term
rates are low and to be inverted when short-term rates
are high; explained by the liquidity premium term in the
first case and by a low expected average in the second
case
Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
FIGURE 6 YIELD CURVES AND THE MARKET’S EXPECTATIONS OF
FUTURE SHORT-TERM INTEREST RATES ACCORDING TO THE
LIQUIDITY PREMIUM (PREFERRED HABITAT) THEORY
FIGURE 7 YIELD CURVES FOR U.S.
GOVERNMENT BONDS
Sources: Federal Reserve Bank of St. Louis; U.S. Financial Data, various issues; Wall Street Journal, various dates.
APPLICATION: THE SUBPRIME COLLAPSE AND
THE BAA-TREASURY SPREAD
Corporate Bond Risk Premium and Flight to
Quality
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Corporate bonds, monthly data Aaa-Rate
Corporate bonds, monthly data Baa-Rate
10-year maturity Treasury bonds, monthly data