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)

ECO553 – Monetary Economics

March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG

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%


March 2012/SH.WONG

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.


Jan 2010/SH.WONG ECO553 – Monetary Economics

March 2012/SH.WONG

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.


March 2012/SH.WONG

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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March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG

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


March 2012/SH.WONG


March 2012/SH.WONG

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


March 2012/SH.WONG

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%


March 2012/SH.WONG

5

Dm

4

3

2

1


B (RM million)

1


anded, Q

5

Dm

3

1

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


L (RM million)

Bs

Ld

C P=RM8000

C i=25% D P=RM9520

D i=5%


March 2012/SH.WONG

5

Dm

4

3

2

1


B (RM million)

1


anded, Q

5

Dm

3

1

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


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


March 2012/SH.WONG

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


March 2012/SH.WONG

5

Dm

4

3

2


B (RM million)

1


anded, Q

5

Dm

3

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


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


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


March 2012/SH.WONG


March 2012/SH.WONG


March 2012/SH.WONG

5

Dm

4

3

2


B (RM million)

1


anded, Q

5

Dm

3

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


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


issuing bonds rises


issuing bonds falls


to borrow falls


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


March 2012/SH.WONG


March 2012/SH.WONG


March 2012/SH.WONG

5

Dm

4

3

2


B (RM million)

1


anded, Q

5

Dm

3

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


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


March 2012/SH.WONG

5

Dm

4

3

2


B (RM million)

1


anded, Q

5

Dm

3

0 4 8 10

2


Pri

ce o

f B

on

ds,

P (

RM

)

Inte

rest

Rate

,

i (

%)


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


March 2012/SH.WONG

• 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


March 2012/SH.WONG


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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


March 2012/SH.WONG


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


March 2012/SH.WONG

5

Dm

4

3

2


B (RM million)

1


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


March 2012/SH.WONG

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


March 2012/SH.WONG

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)


March 2012/SH.WONG

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

March 2012/SH.WONG


March 2012/SH.WONG


March 2012/SH.WONG

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


March 2012/SH.WONG


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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


March 2012/SH.WONG


March 2012/SH.WONG

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


March 2012/SH.WONG

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

4. the behaviour of interest rates

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