Flashcards in Topic 4: Interest Rate Determination Deck (68)
unforeseen transaction, e.g., medical bill or car accident bill
left over money for investment on bonds, which earns interest amount
Liquidity Preference Framework Assumptions
1 - only two financial markets: Money market (short-term) and bonds market (long-term)
2 - only two choices to store their wealth: Money (Cash or cheques or bank deposits) and Bonds
3 - The amount of money or bonds held cannot be equal zero
4 - Return on Money = 0 or negligible
5 - Return on Bonds > 0 and = interest rate (𝑖)
6 - Bonds are not risky
7 - Central bank controls the amount of money supplied in the economy
Liquidity Preference Framework Due to assumptions 1 and 2
1. There are only two financial markets: Money market (short-term) and bonds market (long-term).
2. People in the economy have only two choices to store their wealth: Money (Cash or cheques or bank deposits) and Bonds.
- Total (Financial) wealth in the economy = Money + Bonds.
- In supply-demand language, we can write this as follows:
𝑩𝒔 + 𝑴𝒔=𝑩𝒅 + 𝑴𝒅 −−−−−−−(𝟏)
We can also write EQ (1) as:
𝑩𝒔−𝑩𝒅= 𝑴𝒅 –𝑴𝒔−−−−−−−−−(𝟐)
- If the Money market is in equilibrium (𝑴𝒅=𝑴𝒔), then bond market is also in equilibrium, converse is also true.
Note: Right hand side of EQ (2) forms a basis for liquidity preference theory and Left hand side of EQ (2) forms a basis for loanable fund theory.
Liquidity Preference Framework Due to assumptions 4-6
4 Return on Money = 0 or negligible
5 Return on Bonds > 0 and = interest rate (𝒊)
6 Bonds are not risky
increase in the 𝑖 will increase the 𝐵d, and consequently will reduce the 𝑀𝑑
- 𝑀𝑑 is inversely related with 𝑖
- If you hold money you will lose interest amount that is otherwise available with holding bonds, this is simply called as Opportunity Cost of holding money
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝒎𝒐𝒏𝒆𝒚
𝑭𝒐𝒓𝒆𝒈𝒐𝒏𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 that is available with holding bonds
Liquidity Preference Framework Due to assumptions 7
Central bank controls the amount of money supplied in the economy.
The 𝑀𝑆 curve will be a vertical line.
𝑀𝑆 curve is insensitive to changes in 𝑖.
Two factors responsible for shifting the 𝑀𝑑 curve in Keynes liquidity preference framework are:
1. Income effect
Increase in income leads to an increase in demand for money.
2. Price-level effect
Increasing prices lead to a fall in purchasing power which causes increase in money demand.
Factors responsible for shifting the 𝑀𝑠 curve
Central Bank buys Government securities which causes the money supply to increase
Central Bank sells Government securities which causes the money supply to fall
Effects of Money on Interest Rate
Liquidity Effect - expansionary monetary policy means lower interest rate.
Income Effect - expansionary monetary policy means that higher wages and thereby higher income level.
Price and Expected Inflation Effects - expansionary monetary policy means that higher wages and thereby higher income level.
Effect of higher rate of money growth on interest rates is ambiguous
Would depend whether liquidity effect dominates the income and price level effects or the last two effects dominate the liquidity effect.
Real interest rate
Nominal interest rate – Expected Inflation
Factors that shift the Bond Demand Curve
2. Expected Return and Expected Inflation
Factors that shift the Bond Demand Curve (Wealth)
Economy grows or savings grows , wealth grows , 𝐵𝑑 grows.
Factors that shift the Bond Demand Curve (Expected Return and Expected Inflation)
- 𝑖 decrease in future, 𝑅𝑒 for long-term bonds increase
- 𝜋^𝑒 decreases, Relative 𝑅𝑒 increases
- Expected return on bonds relative to other assets increases, 𝐵𝑑 increases
Factors that shift the Bond Demand Curve (risk)
- Risk of bonds decrease, 𝐵𝑑 increases
- Risk of other assets increases, 𝐵𝑑 increases
Factors that shift the Bond Demand Curve (Liquidity)
Liquidity of Bonds increases, 𝐵𝑑 increases
Liquidity of other assets decreases, 𝐵𝑑 increases
The amount of funds available for lending within the financial system
Perspective of Loan Markets
Provides model of interest rate determination
Supply of Bonds =
Demand for Loanable Funds
Demand for Bonds =
Supply of Loanable Funds
Loan market approach to interest rate determination (The Loanable Funds Approach)
Proposes that the rate of interest is determined by the supply and demand for loanable funds (LF).
LF are the funds available in the financial system for lending
Loanable Funds Theory - As IR Rises
Demand falls and supply increase
Demand for loanable funds has two components
Business demand for funds (B)
- Short-term working capital
- Longer-term capital investment
Government demand for funds (G)
- Finance budget deficits and intra-year liquidity
Supply of loanable funds comprised of three principal sources
Savings of household sector (𝑆) [note: Mishkin also adds Government savings].
Changes in money supply (∆ 𝑀)
is the proportion of total savings in economy held as currency.
as interest rates rise as more securities are purchased for the higher yield available.
theory of portfolio choice
tells us how much of an asset people will want to hold in their portfolios