Interest Rate Determination

1
Interest Rate Determination

• This chapter What makes interest rates move up
  or down?
• Do not confuse with What makes interest rates
  different, such as secondary market, default
  risk, etc.
• Apply Demand and Supply analysis to bond market.

2
Summary Results Shifts in Bond Demand or Supply

• Increase in Bond Demand
• DB? ? i?
• Decrease in Bond Demand
• DB? ? i?
• Increase in Bond Supply
• SB? ? i?
• Decrease in Bond Supply
• SB? ? i ?

3
Shift Variables Bond Demand

• Wealth -- increases increase the Demand for Bonds
• Expected Inflation (?e),
• ?e? ? DB? ? i?

4

• Return or Expected Return on Alternative Assets
• Interest Rates on Bonds of Similar Maturity (for
  specific bond)
• Expected Rate of Return on Stock (RETe)
• Expected future interest rates (ie), ie? ? DB? ?
  i?
• Interest rates on foreign bonds

5

• Market Risk of Bonds and Alternative Assets
• Market Risk of Bonds (?B)
• ?B? ? DB? ? i?
• Market Risk of Stock (?S)
• ?S ? ? DB? ? i?

6

• Changes Affecting Structural Differences
• Changes in Risk Rating of an individual firm
  (Default Risk)
• Changes in Marginal Tax Rate -- affects the
  Demand for Municipal Bonds

7
Shift Variables Supply of Bonds

• Expected Inflation (?e),
• ?e? ? SB? ? i?
• Size of Deficits and National Debt
• Debt ? ? ST-BILLS? ? i?
• Size of State and Local Government Debt
• Debt ? ? SMUN? ? i?

8
More Shift Variables Bond Supply

• Desire for Firms to Undertake Investment Projects
• Investment ? ? SCORP? ? i?
• Loan Demand Faced by Banks
• Loan Demand ? ? SCD? ? i?

9
General Conclusions Interest Rates

• Many factors (not just the Federal Reserve)
  change interest rates.
• Interest rate movements tend to be procyclical,
  or vary positively with the growth the economy.

10
The Federal Reserve and Interest Rates

• Federal Reserve -- practices monetary policy
  through Open Market Operations, the buying or
  selling of T-Bills
• Expansionary Policy (addressing recession) Fed
  buys bonds
• Contractionary Policy (addressing inflation) Fed
  sells bonds

11
Dual Effects Monetary Policy

• Example Federal Reserve practices Expansionary
  Policy to try to improve sluggish economy
• Liquidity Effect
• Fed buys more bonds ? DB? ? i?
• Expected Inflation Effect
• Expansionary policy ? ?e? ? i?
• Overall Effect --- Which one dominates?