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F-309 CH 05 Behavior of Interest Rates

The document discusses the relationship between interest rates and the money supply using the liquidity preference framework. It explains that in this model, interest rates are determined by the supply and demand for money rather than bonds. An increase in the money supply shifts the supply curve to the right, lowering equilibrium interest rates through the liquidity effect as demand is unchanged. However, higher money growth may also shift demand curves due to the income, price level, and expected inflation effects, putting upward pressure on rates. Ultimately, whether interest rates rise or fall depends on which effects dominate in the short and long run.

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Saikat Saha
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29 views

F-309 CH 05 Behavior of Interest Rates

The document discusses the relationship between interest rates and the money supply using the liquidity preference framework. It explains that in this model, interest rates are determined by the supply and demand for money rather than bonds. An increase in the money supply shifts the supply curve to the right, lowering equilibrium interest rates through the liquidity effect as demand is unchanged. However, higher money growth may also shift demand curves due to the income, price level, and expected inflation effects, putting upward pressure on rates. Ultimately, whether interest rates rise or fall depends on which effects dominate in the short and long run.

Uploaded by

Saikat Saha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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The Behavior of Interest Rates

12.00% T-Bill 91

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
2005:M 7 2006:M 3 2006:M 11 2007:M 7 2008:M 3 2008:M 11 2009:M 7 2010:M 3 2010:M 11 2011:M 7 2012:M 3 2012:M 11 2013:M 7 2014:M 3
Supply And Demand in the Market For Money:
The Liquidity Preference Framework

 Keynesian Model: Determines the equilibrium interest rate in terms of the


supply of and demand for money rather than the supply of and demand for
bonds.

 Assumption: People use two main categories of assets to store their wealth:
money and bonds.
 Total Wealth: quantity of bonds supplied (Bs) plus the quantity of money
supplied (Ms)
 The quantity of bonds demanded (Bd) plus the quantity of money demanded
(Md) must also equal the total amount of wealth, because people cannot
purchase more assets than their available resources allow
 Bs + Ms = Bd + Md
 Bs - Bd = Md – Ms
 If the money market is in equilibrium then the bond market must also
be in equilibrium.
Supply And Demand in the Market For Money:
The Liquidity Preference Framework

• Demand for money in the 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.
Supply And Demand in the Market For Money:
The Liquidity Preference Framework
Supply And Demand in the Market For Money:
The Liquidity Preference Framework

• 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
Changes in Equilibrium Interest Rates
in the Liquidity Preference Framework
 Shifts in the Demand for Money
 Income Effect: to store as wealth and to carry out transactions
 Price-Level Effect: if increase (price level), to purchase same quantity of
goods and services their quantity demand for nominal money increases at
each interest rate.
Changes in Equilibrium Interest Rates
in the Liquidity Preference Framework

• Shifts in the supply of money:


– Assume that the 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.
Changes in Equilibrium Interest Rates
in the Liquidity Preference Framework

 Shifts in the Supply for Money


Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?

 Liquidity preference framework leads to the conclusion that an


increase in the money supply will lower interest rates: the liquidity
effect.

 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).
Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?

 Yes
 Liquidity effect dominates and expected inflation adjustment takes place
slowly
Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?

 Liquidity effect is dominated though expected inflation adjustment takes


place slowly
Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?

 Liquidity effect is dominated and expected inflation adjustment takes place


immediately
12.00% 25.00%
T-Bill Rate M2 Growth Rate

10.00%
20.00%

8.00%

M2 Growth Rates
15.00%
T-Bill Rates

6.00%

10.00%
4.00%

5.00%
2.00%

0.00% 0.00%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury
Bills), 1950–2014

Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

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