4. the Behaviour of Interest Rates
Transcript of 4. the Behaviour of Interest Rates
The Behaviour of Interest Rates Ref: Chapters 4, & 5, Miskin (2009, 9th.ed)
Chapters 4, & 6, Hubbard (2008, 6th.ed)
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Interest – the return on capital; to the lender, it is the return received when they extend credit while to the borrower, it is the cost paid when they obtain credit
Interest rate – the cost of borrowing or the price paid for the rental of funds, expressed as a percentage per year
Rate of return – payments to the owner of a security plus the change in the value of the security, expressed as a fraction of its purchase price
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Suppose RM100,000 is lent out and at the end of the year RM110,000 must be paid back
RM100,000 is the principal while RM10,000 is the interest
The interest rate is 10,000/100,000 x 100 = 10%
To the borrower it is a cost while to the lender it is a return
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Nominal interest rate – interest rate that does not take inflation into account
Real interest rate – interest rate adjusted for expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing
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Nominal interest rate = real interest rate + expected inflation rate
Real interest rate = nominal interest rate – expected inflation rate
For example, if the nominal interest rate is 10% per annum and the inflation rate is 3.5%, then the real interest rate is actually 6.5%
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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.
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Categories of credit market instruments are identified based on the variations in the timing of payments received
Simple loan ◦ Involves the principal (P) and interest ( i ) ◦ Total payment = P + iP = P(1 + i )
Discount bond ◦ Repays in a single payment ◦ Repays the face value at maturity, but receives
less than the face value initially.
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Coupon bond ◦ Borrowers make multiple payments of interest
at regular intervals and repay the face value at maturity
◦ Specifies the maturity date, face value, issuer, and coupon rate (equals the yearly payment divided by face value)
Fixed-payment loan ◦ Borrower makes regular periodic payments to
the lender. ◦ Payments include both interest and principal
and no lump-sum payment at maturity.
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Time Lines for Credit Market Instrument Repayment
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Comparing returns across debt types is difficult since timing of repayment differs
Solution is the concept of present value: to find a common measure for funds at different times, present each in today’s ringgit
A ringgit paid to you one year from now is less valuable than a ringgit paid to you today
Why? A ringgit deposited today can earn interest and become RM1 x (1+i) one year from today.
Loan able funds – financial capital which firms and households can borrow; where firms borrow to finance their investment projects while households borrow to finance their purchases of durable goods and services
Savings – amount of present income not spent
Investment – expenditure on capital goods and fixed assets such as buildings, equipment and machines
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Liquidity preference – desire to hold money (cash) instead of other assets
Transactionary motive – amount of money held to enable us to undertake our daily purchases
Precautionary motive – extra amount of money held in case of unforeseen expenditure
Speculative motive – demand for money created by uncertainty about the value of other assets
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Rate of return – the payments to the owner of a security plus the change in the value of the security expressed as a fraction of its purchase price
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There are various types of interest rates like Overnight Policy Rate (OPR), Base Lending Rate (BLR), Islamic Financing Rate (IFR), discount rate, deposit rate, etc, all of which tend to move in the same direction
The two predominant theories on the determination of interest rates
Classical Model Keynesian Model
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Loanable funds theory – introduced by economists under the classical school of thoughts
Generally, interest rates is determined through the interaction of the supply of and demand for loanable funds
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Bond Market where
Bond is the Good
Loanable Funds
Market where Use of
Funds is the Good
Buyer •Lender
buys the bond
•Borrower
raises the funds
Seller •Borrower
sells the bond
•Lender
supplies the funds
Price •Bond price •Interest rate
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5
Dm
4
3
2
1
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
1
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd
Ls
A P=RM8000
A i=25% B P=RM9520
B i=5%
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5
Dm
4
3
2
1
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
1
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bs
Ld
C P=RM8000
C i=25% D P=RM9520
D i=5%
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5
Dm
4
3
2
1
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
1
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd
Ls
A P=RM8000
A i=25%
B P=RM9520
B i=5%
P=RM9090 i=10%
Bs
Ld
C
E D C
E
D
Excess supply
of bonds
Excess demand
for bonds
Excess supply of
loanable funds
Excess demand for
loanable funds
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Changes in demand for bond or supply of bond will change the bond price and interest rate
Theory of portfolio allocation can explain bond demand curve shifts
Changes in willingness and ability to borrow shifts the supply curve
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5
Dm
4
3
2
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd
Ls
E2 P2
E2 i2 1b. Bond
price rises
P1
1b. Interest
rate falls
i1
P0 i0
Bs
Ld
2b. Bond
price falls
E0
E1
E0
E1
2a. Attractiveness of
holding bonds falls
1a. Ability/willingness
to lend rises
1b. Interest
rate rises
2a. Ability/willingness
to lend falls 1a. Attractiveness of
holding bonds rises
Increase in Demand for Bonds
Higher expected returns on bonds
Higher relative liquidity of bonds
Higher wealth
Lower expected inflation
Lower expected return on other assets
Lower relative information costs of bonds
Lower relative riskiness of bonds
Decrease in Demand for Bonds
Lower expected returns on bonds
Lower relative liquidity of bonds
Lower wealth
Higher expected inflation
Higher expected return on other assets
Higher relative information costs of bonds
Higher relative riskiness of bonds
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5
Dm
4
3
2
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd
Ls
E2 P2
E2 i2
1b. Bond
price falls
P1
1b. Interest
rate rises
i1
P0 i0
Bs
Ld
2b. Bond
price rises E0
E1
E0
E1
1a. Attractiveness of
issuing bonds rises
2a. Attractiveness of
issuing bonds falls
2a. Ability/willingness
to borrow falls
1a. Ability/willingness
to borrow rises
1b. Interest
rate falls
Increase in Supply of Bonds
Higher expected profitability of capital
Higher government borrowing
Higher tax subsidies for investment
Lower business tax
Higher expected inflation
Decrease in Supply of Bonds
Lower expected profitability of capital
Lower government borrowing
Lower tax subsidies for investment
Higher business tax
Lower expected inflation
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5
Dm
4
3
2
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd0
Ls0
E1
E1
P1
i1
P0 i0
Bs0
Ld0
3. Bond
price rises E0 E0
2. Expected
profitability falls
1. Household
wealth falls
2. Expected
profitability falls
1. Household
wealth falls
3. Interest
rate falls
Bd1
Bs1
Ls1
Ld1
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5
Dm
4
3
2
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
0 4 8 10
2
Bond Market Perspective Loanable Funds Perspective
Pri
ce o
f B
on
ds,
P (
RM
)
Inte
rest
Rate
,
i (
%)
Quantity of Loanable Funds,
L (RM million)
Bd0
Ls0
Bs1
Bd1
3. Bond
price
falls
P1
i1
P0 i0
Bs0
Ld0
E0
E1
E0
E1
1. Higher expected
inflation reduces
demand for bonds
2. Higher expected
inflation increases
supply of bonds
2. Higher expected inflation
increases demand for
loanable funds
1. Higher expected inflation
reduces supply of loanable
funds
Ls1
Ld1
3. Interest
rate
rises
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• Closed Economy: an economy that neither borrows nor lends to foreign countries
• Open Economy: capital is mobile internationally
• World real interest rate (rw): the interest rate that is determined in the international capital market
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Small open economy: the quantity of loanable funds supplied is too small to affect the world interest rate and the economy takes rw as given
Large open economy: an economy that is large enough to affect the world interest rate
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Quantity Demanded, Q
anded, Q
5
Dm
3
1
0 4 8 10
2
Loanable Funds Perspective
World
Real
Inte
rest
Rate
,
rw (
%)
Quantity of Domestic Loanable
Funds, L (RM million)
Ls
A rw1=5%
B rw2=1%
rw*=3%
Ld
C
E
D
International lending; domestic
desired lending exceeds
domestic desired borrowing
International borrowing;
domestic desired borrowing
exceeds domestic desired lending
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5
Dm
4
3
2
0 6 Quantity of Bonds,
B (RM million)
1
Quantity Demanded, Q
anded, Q
5
Dm
3
1
0 4 8 10
2
Worl
d R
eal
Inte
rest
Rate
, r w
(%
)
Worl
d R
eal
Inte
rest
Rate
, r w
(%
) Quantity of Loanable Funds,
L (RM million)
Ld
Ls
rw=3
Rest of the World United States
3
rw= 5 5
Ls
Ld
US lends
abroad
Rest of World
borrows abroad
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Liquidity preference theory – introduced by John Maynard Keynes
Based on the demand to hold money in liquid form for the purpose of transaction, precaution and speculative
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The equilibrium interest rate is determined through the supply of and demand for money
Two main categories of assets to store wealth: money and bonds
Total wealth in the economy: Bs + Ms = Bd + Md
Bs - Bd = Ms - Md When the money market is in equilibrium
(Ms = Md) then the bond market is also in equilibrium (Bs = Bd)
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16%
12%
8%
4%
500 1,500 2,000
E
The Money Market Equilibrium
Demand for
Money,Md
Supply of
Money, Ms
Surplus
Shortage
1,000
Inte
rest
Rat
e
Quantity of Money
(RM million) ECO553 – Monetary Economics
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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
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Assume that the supply of money is controlled by the central bank
An increase in the money supply engineered by the central bank will shift the supply curve for money to the right
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Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates—the liquidity effect
Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy
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
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
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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