chapter 5 the behavior of interest rates
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Interest Rates 2000-2013
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Fed Funds 10-yr Treas
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Chapter 5The Behavior of Interest Rates
Interest rate are low today because of: • QE-4, Fed buying $30 b of MBS and $35 b of Treasury bonds each
month.
• Eurozone debt crisis
• Corporate sector excess cash
• Financial institutions’ large surplus funds
Investors will adjust their portfolios in expectation of when the Fed will tighten monetary policy.
• Fed is reducing its of bond buying and could exit QE by the end of 2013 if economic growth accelerates. This will increase Treasury yields and reduce bond prices. So investor demand for longer-term bonds will decline, pushing up interest rates.
• Markets expect Fed to end ZIRP in first quarter of 2015. Fed will raise fed funds rate when the unemployment rate falls below 6.5% and 2-year inflation expectations rise above 2.5%.
• Banks are decreasing interest rate risk by investing short term.
The Big QuestionDoes a MS => i ?
Effects of MS on i1. Liquidity EffectMs , Ms shifts right, i
2. Income EffectMs , Income , Md , Md , i
3. Price Level EffectMs , Permanent Price level , Md , Md , i
4. Expected Inflation EffectMs => e => Bd & Bs (Fisher effect) => i
Answer: Effect of higher M/M on i is ambiguous
If assume Ceteris Paribus
Derivation of Bond Demand CurveAssume1. 1-Yr discount bond (no coupon payments)2. Pays $1,000 face value in one year3. Holding period = 1 year , then return = i = YTM
i = RetE = (F – P)/P
For each P, there is a corresponding i
If P = $950, then i = (1,000 - $950)/950 = 0.053Assume QD = $100 billion
If P = $750, then i = (1,000 - $750)/750 = 0.333Assume QD = $500
Law of Demand (lower price => higher QD) (higher return => higher QD)
Determinants of Asset Demand
QD = f(P/i; Wealth, RE, Risk, Liquidity) + + - +
•Wealth = total resources ownedY => W => DB MPS => W => DB
•RE = C/P + (PEt+1- Pt)/Pt
iEt+1 => PE
t+1 => RE => DB E => relative RE DB relative to other assets
•Risk = degree of return uncertaintyrelative to other assets
•Liquidity = ease and speed of turning asset into cash relative to other assets
Factors That Lower Long-Term Interest Rates by Increasing the Demand for Bonds
Wealth: Economic Expansion => Increasing wealth => increased demand for bonds => Pbonds increases => rbonds
decreases
Expected Interest Rates:Lower expected interest rates in the future => raise the expected return of long-term bonds => increased
demand for bonds => Pbonds increases => rbonds decreases
Stock Market:Lower expected stock prices in the future => expected return on bonds relative to stocks would rise =>
increased demand for bonds => Pbonds increases => rbonds decreases
Expected Inflation:Falling expected rate of inflation => raises the expected return on bonds relative to the expected return on
real assets => increased demand for bonds => Pbonds increases => rbonds decreases
Risk:Increase in riskiness of alternative assets => increased demand for bonds => Pbonds increases => rbonds
decreases
Liquidity:Decreased liquidity of alternative assets => increased demand for bonds => Pbonds increases => rbonds
decreases
Bond Supply CurveRelationship between QS and P
As P , i => less costly for firms to borrow => borrowing => QS
QS = f(P/i; I, E, Def.) +/- + + +
• I = Profitability of investment opportunitiesAD => P => = PY – Costs => I =>Y
• E = Expected inflation (return on real assets)
r = i - E
•Def. = Government Deficits
Evidence on the Fisher Effect in the United States
Evidence on Business Cycles and Interest Rates
Business Fixed Investment(Nonresidential Structures)
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Annualized Quarter Growth Rate
% Change From Quarter One Year Ago
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Nominal Interest Rates, Real Interest Rates and Inflation Expectations
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Source: Federal Reserve
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Inflation Expectations 10-yr Treas TIPS (10-Yr)
Evidence on Money Growth and Interest Rates
Econ 330
Homework 3Due Friday, February 14
Chapter 5Questions & Applied Problems: 14, 18, 19, 20, 23, 24, 25
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