Topic 4: Interest Rate Determination Flashcards Preview

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Flashcards in Topic 4: Interest Rate Determination Deck (68)
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31

Transactions motive

day-to-day use

32

Precautionary motive

unforeseen transaction, e.g., medical bill or car accident bill

33

Speculative motive

left over money for investment on bonds, which earns interest amount

34

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

35

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 βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’(𝟏)

We can also write EQ (1) as:

π‘©π’”βˆ’π‘©π’…= 𝑴𝒅 β€“π‘΄π’”βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’βˆ’(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.

36

Liquidity Preference Framework Due to assumptions 4-6

Assumptions:
4 Return on Money = 0 or negligible
5 Return on Bonds > 0 and = interest rate (π’Š)
6 Bonds are not risky

increase in the 𝑖 will increase the 𝐡d, 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

37

π‘Άπ’‘π’‘π’π’“π’•π’–π’π’Šπ’•π’š π‘ͺ𝒐𝒔𝒕 𝒐𝒇 π’‰π’π’π’…π’Šπ’π’ˆ π’Žπ’π’π’†π’š

π‘­π’π’“π’†π’ˆπ’π’π’† π’Šπ’π’•π’†π’“π’†π’”π’• that is available with holding bonds

38

Liquidity Preference Framework Due to assumptions 7

Assumption 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.

39

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.

40

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

41

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.

42

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.

43

Real interest rate

Nominal interest rate – Expected Inflation

44

Factors that shift the Bond Demand Curve

1. Wealth
2. Expected Return and Expected Inflation
3. Risk
4. Liquidity

45

Factors that shift the Bond Demand Curve (Wealth)

Economy grows or savings grows , wealth grows , 𝐡𝑑 grows.

46

Factors that shift the Bond Demand Curve (Expected Return and Expected Inflation)

- 𝑖 decrease in future, 𝑅𝑒 for long-term bonds increase
- πœ‹^𝑒 decreases, Relative 𝑅𝑒 increases
- Expected return on bonds relative to other assets increases, 𝐡𝑑 increases

47

Factors that shift the Bond Demand Curve (risk)

- Risk of bonds decrease, 𝐡𝑑 increases
- Risk of other assets increases, 𝐡𝑑 increases

48

Factors that shift the Bond Demand Curve (Liquidity)

Liquidity of Bonds increases, 𝐡𝑑 increases
Liquidity of other assets decreases, 𝐡𝑑 increases

49

Loanable Funds

The amount of funds available for lending within the financial system

50

Perspective of Loan Markets

Provides model of interest rate determination

51

Supply of Bonds =

Demand for Loanable Funds

52

Demand for Bonds =

Supply of Loanable Funds

53

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

54

Loanable Funds Theory - As IR Rises

Demand falls and supply increase

55

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

56

Supply of loanable funds comprised of three principal sources

Savings of household sector (𝑆) [note: Mishkin also adds Government savings].

Changes in money supply (βˆ† 𝑀)

Dishoarding (𝐷)

57

Hoarding

is the proportion of total savings in economy held as currency.

58

Dishoarding occurs

as interest rates rise as more securities are purchased for the higher yield available.

59

theory of portfolio choice

tells us how much of an asset people will want to hold in their portfolios

60

theory of portfolio choice, states that, holding all other factors constant:

quantity demanded of an asset is positively related to
1. wealth.
2. its expected return relative to alternative assets.
3. its liquidity relative to alternative assets.

The quantity demanded of an asset is negatively related to
1. the risk of its returns relative to alternative assets.