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The determination of bond prices and interest rates

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## The determination of bond prices and interest rates

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**The determination of bond prices and interest rates**Mishkin, Chap 5**Chap 5 discusses:**• The classical theory of bond prices and interest rates • The liquidity preference theory (Keynesian theory) of bond prices and interest rates • Critique of the liquidity preference theory - Money supply and the market interest rates**Difference between a market for loans and a bond market –**a recap • In a market for loans, the interest rate on a loan is determined by market forces of demand and supply. • Given a LV and n, the FP is then determined from the PV relationship. Equivalently, given FP and n, the LV is then determined from the PV relationship. • In a market for bonds, the bond price is determined by market forces or demand and supply. • Given C, FV and n, the interest rate or yield to maturity is then determined from the PV relationship. • Thus the difference lies in which is regarded as the market determined variable – price or interest rate.**The classical theory of bond prices and interest rates**• Demand for a bond (generally for any asset) depends on: • average time preference of households; the more willing the households are to defer their current consumption, the _________ the demand. • average wealth level of households ; the higher the wealth level, the _______ the demand • expected return on the bond over the holding period; the greater the expected return the ________ the demand • the risk on the bond; assuming agents to be risk averse, the greater the risk, the ________ the demand. Risk is often measured by _______ • the liquidity of the bond; the greater the liquidity the _______ the demand. Liquidity is often measured by ________**Demand for bonds**Given wealth, savings propensities, risk and liquidity, quantity demanded of bond is _________ related to the expected return on it. If so, how is the quantity demanded related to the current market price of the bond? Hint: Back to chap 4 for short term investors: one period RET = (C + Pt+1 – Pt)/Pt for someone who holds till maturity: RET = YTM based on the current market price How is RET related to Pt in both cases? Hence quantity demanded is _______ related to current market price. The demand curve for bonds shows**Supply of bonds**From the issuer’s (borrower’s) point of view, what is the cost of borrowing? Hence, quantity supplied of bonds is _______ related to its current market price everything else constant. The supply curve of a bond shows Equilibrium in the bond market: the price at which quantity demanded ________ quantity supplied. If bond price > market clearing price If bond price < market clearing price Equilibrium price implies a corresponding equilibrium interest rate. Why?**price of the bond**• Draw the demand and supply of the bond. Indicate the sources of each (who demands or supplies?) • Add a third interest rate axis to alternatively express these relationships. quantity of the bond**The market for loanable funds is another name for the market**for bonds. Demand for bonds = __________ loanable funds;Supply of bonds = __________ loanable funds; Interest rate Draw the supply of and demand for loanable funds and also mark them with their alternative labels. Quantity of bonds**Factors affecting demand, supply and the equilibrium**interest rate • increase in the average wealth level? • 2. increase in expected (future) interest rate? Price of the bond S0 D0 Quantity of the bond Price of the bond Hint: What happens to the future price of the bond? What happens to the one period rate of return? S0 D0 Quantity of the bond**3. increase in the expected return on an alternative asset**such as a stock or another bond? 4. increase in the riskiness of the bond; effect on an alternative asset Price of the bond S0 D0 Quantity of the bond P S0 D0 Q**5. increase in the liquidity of the bond? effect on an**alternative asset 6. Increase in the expected (future) inflation rate, assuming this is a nominal bond? P S0 D0 Q P What happens to the equilibrium nominal interest rate? S0 D0 Q**increase in business profitability?**• 8. increase in the government budget deficit? P S0 D0 Q P S0 D0 Q**Changes in e: the Fisher Effect**Price of a bond What happens to demand and supply as πeincreases? Are the shifts equal? What happens to equilibrium price? Equilibrium quantity? Equilibrium nominal interest rate? S0 D0 Quantity of bond**Effects of Business cycles - expansion**Price of a bond What happens to demand and supply during expansions? Are the shifts equal? What happens to equilibrium price? Equilibrium quantity? Equilibrium interest rate? S0 D0 Quantity of bond**II. Liquidity preference or Keynesian theory of the**interest rate • Assume only 2 types of assets, bonds and money • Bs + Ms = Bd + Md = total wealth of individuals • or Bs – Bd = Md – Ms • If the money market is ___________, the bond market is ____________also. Excess ________ in the bond market implies excess _______ in the money market and the reverse. • The bond market can be analyzed by analyzing the money market. (Note: method doesn’t work if there are more than 2 assets) • Demand for money: money is demanded • because of its • this component depends on • because it can act as a • this component**Supply of money: assumed constant for the present**Money market equilibrium: assuming _______ price level and income level, the __________ at which Md = Ms Interest rate The demand for and supply of money and show the equilibrium interest rate. Quantity of money**Factors that affect demand, supply and the equilibrium**interest rate, according to the liquidity preference theory: 1. an increase in income? 2. an increase in the price level? 3. An increase in money supply? Interest rate i Quantity of money M i (3) is called the liquidity effect of an increase in money supply. M**III. Critique of LP theory**Major difference between the classical and the Keynesian (LP) theory: The Keynesian theory ignores some other effects of an increase in money supply on the interest rate. These are - - - Of the above three, the classical theory of interest emphasizes _____ as the most important quantitatively in the long run.