chapter 6: learning objectives interest rate level determination:
TRANSCRIPT
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Chapter 6:Learning Objectives
Interest Rate Level Determination:
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes Applications:
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes Applications:
Fisher effect
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes Applications:
Fisher effect interest rates over the business cycle
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Chapter 6:Learning Objectives
Interest Rate Level Determination: Loanable funds vs. Liquidity preference
Equilibrium Determination & Changes Applications:
Fisher effect interest rates over the business cycle the impact of a tight monetary policy
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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
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Loanable Funds Theory
Focus is on the Market for bonds
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Loanable Funds Theory
Focus is on the Market for bonds Bond demand (Bd) is determined by investors’
preferences
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Loanable Funds Theory
Focus is on the Market for bonds Bond demand (Bd) is determined by investors’
preferences Bond supply (Bs) is determined by borrowers’
preferences
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Loanable Funds Theory
Focus is on the Market for bonds Bond demand (Bd) is determined by investors’
preferences Bond supply (Bs) is determined by borrowers’
preferences For discussion purposes, ASSUME a one-year
discount bond $PD is inversely related to R (=[$FV-$PD]/$PD
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Loanable Funds Theory
Focus is on the Market for bonds Bond demand (Bd) is determined by investors’
preferences Bond supply (Bs) is determined by borrowers’
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
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BOND DEMAND=SUPPLY OF LOANABLE FUNDS
From Bond demand/supply to Loanable funds demand/supply
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From Bond demand/supply to Loanable funds demand/supply
BOND DEMAND=SUPPLY OF LOANABLE FUNDS
BOND SUPPLY=DEMAND FOR LOANABLE FUNDS
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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
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Shifts in Loanable Funds demand/supply
DEMAND SIDE INFLUENCES
Wealth (+ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns
(+ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve)
Liquidity (+ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
Expected returns (+ve)
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
Expected returns (+ve) Govt policies (?)
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve)
SUPPLY SIDE INFLUENCES
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Shifts in Loanable Funds demand/supply
Expected returns (+ve) Govt policies (?) Expected Inflation (+ve)
DEMAND SIDE INFLUENCES
Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve)
SUPPLY SIDE INFLUENCES
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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
•
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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
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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
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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
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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’
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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
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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
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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
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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%
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Liquidity Preference Theory
Focus is on the role of monetary policy
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Liquidity Preference Theory
Focus is on the role of monetary policy Demand for money (Md) is determined by the
preferences of holders of money ( M1)
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Liquidity Preference Theory
Focus is on the role of monetary policy Demand for money (Md) is determined by the
preferences of holders of money ( M1) Supply of Money is determined by the central
bank and the financial sector
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Liquidity Preference Theory
Focus is on the role of monetary policy Demand for money (Md) is determined by the
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
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Why Hold Money?
TRANSACTIONS MOTIVE: used in the buying and selling of goods and services
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Why Hold Money?
TRANSACTIONS MOTIVE: used in the buying and selling of goods and services
PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events
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Why Hold Money?
TRANSACTIONS MOTIVE: used in the buying and selling of goods and services
PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events
SPECULATIVE MOTIVE: represents one asset in a “portfolio” of assets
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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
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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
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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
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The (Dynamic) Link Between Money Growth and the Interest Rate
Time
0
1
2
R
R0
R1
R2
Time
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The Liquidity Trap
When nominal interest rates are close to zero can monetary policy be effective
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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
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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
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Summary
There are 2 theories of interest rate determination: the loanable funds and liquidity preference models
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Summary
There are 2 theories of interest rate determination: the loanable funds and liquidity preference models
Loanable funds focuses on the bond market
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Summary
There are 2 theories of interest rate determination: the loanable funds and liquidity preference models
Loanable funds focuses on the bond market Liquidity preference focuses on the demand for money
and the role of monetary policy
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Summary
There are 2 theories of interest rate determination: the loanable funds and liquidity preference models
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