Understanding

Interest Rates
&
Its Behaviour
 Chapter Preview

Interest rates are among the most closely watched variables in

the economy. It is imperative that what exactly is meant by
the phrase interest rates is understood.

• Types of bonds and their relevant interest rates

• Why do interest rates fluctuate over time
 Measuring Interest Rates
Present Value: A dollar paid to you one year from now is less
valuable than a dollar paid to you today

Why?
A dollar deposited today can earn interest and become
$1 x (1+i) one year from today.
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121

Discounting the Future or 100 X (1 + 0.10) 2

In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i ) n
 Simple Present Value
PV = today's (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i ) n
Time Line

Cannot directly compare payments scheduled in different

points in the time line

$100 $100 $100 $100

Year 0 1 2 n

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Present Value of Cash Flows: Example
 Four Types of Credit Market Instruments

• Simple Loan - Require payment of one amount which equals

the loan principal plus the interest.
• Fixed Payment Loan - The loan principal and interest are
repaid in several payments, often monthly, in equal dollar
amounts over the loan term.

• Coupon Bond

• Discount Bond
 Simple Loan Terms

• Loan Principal: the amount of funds the lender provides to

the borrower.
• Maturity Date: the date the loan must be repaid; the Loan
Term is from initiation to maturity date.
• Interest Payment: the cash amount that the borrower must
pay the lender for the use of the loan principal.
• Simple Interest Rate: the interest payment divided by the
loan principal; the percentage of principal that must be paid
as interest to the lender. Convention is to express on an
annual basis, irrespective of the loan term.
 Simple Loan

PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
 Fixed Payment Loan

The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n
 Coupon Bond

Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=    . . . + 
1+i (1+i ) 2 (1+i )3 (1+i) n (1+i ) n
 Discount Bond
(Zero Coupon Bond)

One-Year Discount Bond (P = $900, F = $1000)

$1000
$900  
1  i

$1000  $900
i  .111  11.1%
$900

FP
i
P
The Distinction Between Interest Rates and Returns
Rate of Return: The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P -P
RET = + t1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt

Prices and returns for long-term bonds are more volatile

than those for shorter-term bonds
The Distinction Between Real and Nominal Interest Rates

• Nominal interest rate makes no allowance for inflation

• Real interest rate is adjusted for changes in price level so it
more accurately reflects the cost of borrowing
• Ex ante real interest rate is adjusted for expected changes in the
price level
• Ex post real interest rate is adjusted for actual changes in the
price level

Fisher Equation:
Distinction Between Real and Nominal Interest Rates

Real interest rate ir  i   e

We usually refer to this rate as the ex ante real rate of interest

because it is adjusted for the expected level of inflation. After the
fact, we can calculate the ex post real rate based on the observed
level of inflation

1. Real interest rate more accurately reflects true cost of

borrowing
2. When the real rate is low, there are greater incentives to
borrow and less to lend
 Real and Nominal Interest Rates (Three-Month Treasury Bill)
1953–2011

Sources: Nominal rates from www.federalreserve.gov/releases/H15 and inflation from

ftp://ftp.bis.gov/special.requests/cpi/cpia.txt. 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.
 The Behavior
of
Interest Rates

Why Do Interest Rates Change?

 Bond Market and Interest Rates
In the early 1950s, short-term Treasury bills were yielding
about 1%. By 1981, the yields rose to 15% and higher. But
then dropped back to 1% by 2003.
 Determinants of Asset Demand

An asset is a piece of property that is a store of value. Facing the

question of whether to buy and hold an asset or whether to buy
one asset rather than another, an individual must consider the
following factors:
1. Wealth, the total resources owned by the individual,
including all assets
2. Expected return (the return expected over the next
period) on one asset relative to alternative assets
3. Risk (the degree of uncertainty associated with the
return) on one asset relative to alternative assets
4. Liquidity (the ease and speed with which an asset can be
turned into cash) relative to alternative assets
 Expected Return
What is the expected return on an Lanka-Bangla bond if the return
is 12% two-thirds of the time and 8% one-third of the time?
Solution
The expected return is 10.68%.
Re = p1R1 + p2R2
where
p1 = probability of occurrence of return 1 = 2/3 = .67
R1 = return in state 1 = 12% = 0.12
p2 = probability of occurrence return 2 = 1/3 = .33
R2 = return in state 2 = 8% = 0.08
Thus
Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%
 A measure of risk: Standard Deviation

A measure of risk is standard deviation as follows:

2 1
  p1 ( R1  E ( R)) 2  p2 ( R2  E ( R)) 2  (0.12  0.1068) 2  (0.33  0.168) 2  .094
3 3
Determinants of Asset Demand
 The Bond Market
Let’s consider a one-year discount bond with a face value of
$1,000. In this case, the return on this bond is entirely determined
by its price. The return is, then, the bond’s yield to maturity.

Derivation of Demand Curve

F  P 
iR 
e

Point A: if the bond was Point B: if the bond was

selling for $950. selling for $900.
P  $950 P  $900
$1000  $950  $1000  $900 
i  .053  5.3% i  .111  11.1%
$950 $900
B  100
d
B  200
d
Supply and Demand for Bonds
 Market Equilibrium
The equilibrium follows what we know from supply-demand analysis:
1. Occurs when Bd = Bs, at P* = 850, i* = 17.6%
2. When P = $950, i = 5.3%, Bs > Bd
(excess supply): P  to P*, i  to i*
3. When P = $750, i = 33.0, Bd > Bs
(excess demand): P  to P*, i  to i*

Market equilibrium occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to sell (supply) at a given price
Excess supply occurs when the amount that people are willing to sell (supply) is
greater than the amount people are willing to buy (demand) at a given price
Excess demand occurs when the amount that people are willing to buy (demand) is
greater than the amount that people are willing to sell (supply) at a given price
 Changes in Equilibrium Interest Rates

We now turn our attention to

changes in interest rate. We focus
on actual shifts in the curves.
Remember: movements along the
curve will be due to price changes
alone.

Factors That Shift

Demand Curve
 Summary of Shifts in the Demand for Bonds

1. Wealth: in a business cycle expansion with growing wealth,

the demand for bonds rises, conversely, in a recession, when
income and wealth are falling, the demand for bonds falls
2. Expected returns: higher expected interest rates in the future
decrease the demand for long-term bonds, conversely, lower
expected interest rates in the future increase the demand for
long-term bonds
3. Risk: an increase in the riskiness of bonds causes the demand
for bonds to fall, conversely, an increase in the riskiness of
alternative assets (like stocks) causes the demand for bonds
to rise
4. Liquidity: increased liquidity of the bond market results in an
increased demand for bonds, conversely, increased liquidity of
alternative asset markets (like the stock market) lowers the
demand for bonds
 Changes in Equilibrium Interest Rates

Factors That Shift

Supply Curve
 Summary of Shifts in the Supply for Bonds

1. Expected Profitability of Investment Opportunities: in a

business cycle expansion, the supply of bonds increases,
conversely, in a recession, when there are far fewer
expected profitable investment opportunities, the supply
of bonds falls
2. Expected Inflation: an increase in expected inflation (real
cost of borrowing goes down) causes the supply of bonds
to increase
3. Government Activities: higher government deficits
increase the supply of bonds, conversely, government
surpluses decrease the supply of bonds.
 Application: Fisher Effect

Changes in πe

• If πe 
1. Relative Re ,
Bd shifts
in to left
2. Bs , Bs shifts
out to right
3. P , i 
 Evidence on the Fisher Effect in the US

Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate:
An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These
procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends.
 Summary of the Fisher Effect

1. If expected inflation rises from 5% to 10%, the expected

return on bonds relative to real assets falls and, as a
result, the demand for bonds falls
2. The rise in expected inflation also means that the real
cost of borrowing has declined, causing the quantity of
bonds supplied to increase
3. When the demand for bonds falls and the quantity of
bonds supplied increases, the equilibrium bond
price falls
4. Since the bond price is negatively related to the interest
rate, this means that the interest rate will rise
 Application: Business Cycle Expansion

1. Wealth , Bd , Bd
shifts out to right
2. Investment , Bs ,
Bs shifts right
3. If Bs shifts
more than Bd
then P , i 
Evidence on Business Cycles
and Interest Rates
 The Practicing Manager

We now turn to a more practical side to all this. Many firms

have economists or hire consultants to forecast interest rates.
Although this can be difficult to get right, it is important to
understand what to do with a given interest rate forecast.

Profiting from Interest-Rate Forecasts

• Make decisions about assets to hold

1. Forecast i , buy long bonds
2. Forecast i , buy short bonds

• Make decisions about how to borrow

1. Forecast i , borrow short
2. Forecast i , borrow long
 Supply and Demand in the Market for Money:
The Liquidity Preference Framework

Keynesian model that determines the equilibrium interest rate

in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs  M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).
 Demand for Money in Liquidity Preference Framework

• As the interest rate increases:

• The opportunity cost of holding money increases…
• The relative expected return of money decreases…
• …and therefore the quantity demanded of money decreases.

Shifts in the demand for money:

• 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
 Shifts in the Supply of Money

• Supply of money is controlled by the central bank

• An increase in the money supply engineered by the Federal
Reserve will shift the supply curve for money to the right

Tools the CB can use to change the MS:

• OMO
• Reserve Requirement
• Discount Rate
Equilibrium in the Market for Money
Factors That Shift the Demand and Supply of Money
Response to a Change in Income or the Price Level
Response to a Change in the Money Supply
Does a Higher Rate of Growth of the Money Supply
Lower Interest Rates?

• Liquidity effect: An increase in the MS will lower interest rates:

• Income effect: finds interest rates rising because increasing the
money supply is an expansionary influence on the economy
(the demand curve shifts to the right).
• 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 (the demand curve shifts to the right).
• 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 (the demand curve
shifts to the right).
Response over Time to an Increase in
Money Supply Growth
 Money Growth and Interest Rates
Three-Month Treasury Bills, 1950–2011

Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.