The determination of bond prices and interest rates

1
The determination of bond prices and interest
rates

• Mishkin, Chap 5

2

• 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

3

• 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.

4

• 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 ________

5
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 Pt1 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
6
Supply of bonds From the issuers (borrowers)
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 gt market
clearing price If bond price lt market clearing
price Equilibrium price implies a corresponding
equilibrium interest rate. Why?
7
price of the bond

1. Draw the demand and supply of the bond. Indicate
   the sources of each (who demands or supplies?)
2. Add a third interest rate axis to alternatively
   express these relationships.

quantity of the bond
8
The market for loanable funds is another name for
the market for bonds. Demand for bonds
__________ loanable fundsSupply 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
9

• 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
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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
11
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
12

• increase in business profitability?
• 8. increase in the government budget deficit?

P
S0
D0
Q
P
S0
D0
Q
13
Changes in ?e the Fisher Effect
Price of a bond
What happens to demand and supply as pe
increases? Are the shifts equal? What happens
to equilibrium price? Equilibrium
quantity? Equilibrium nominal interest rate?
S0
D0
Quantity of bond
14
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
15

• 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 doesnt 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

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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
17
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
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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.