CHAPTER 06: THE RISK AND TERM STRUCTURE OF INTEREST RATES

Risk & Term Structure of Interest Rate:

1. The risk structure of interest rate explains why bonds with the same maturity have different interest
rates.
2. The term structure of interest rate explains why bonds with identical risk and different maturity have
different interest rates.

The Risk Structure of Interest Rate:

Bonds with the same maturity have different interest rates due to:
1. Default risk
2. Liquidity
3. Tax considerations

Default Risk:
Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay
off the face value.
• Govt. Treasury bonds are considered default free (government can raise taxes to pay off the debt).
• Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on
(same maturity) Treasury bonds
Response to an Increase in Default Risk on Corporate Bonds

Assuming that initially, both bonds have same default risk, thus initial equilibrium prices and interest rates are
equal (PC1=PT1 and iC1=iT1), thus, risk premium (iC1=iT1) is zero. An increase in default risk shifts the demand
curve for corporate bonds left.

And shifts the demand curve for Treasury bonds to the right. This raises the price of Treasury bonds and lowers
the price of Corporate bonds, and, lowers the interest rate on Treasury bonds and raises the rate on Corporate
bonds. Thus, increasing the spread between the interest rates on Corporate vs Treasury bonds.

Liquidity
Liquidity is the relative ease with which an asset can be converted into cash
• Time & cost of selling a bond
• Number of buyers/sellers in a bond market

1. The more liquid a bond is, the more desirable it is.

2. Treasury bonds are the most liquid
3. Lower liquidity of corporate bonds increases the spread between the interest rates.
4. Risk premium is more accurately a ‘risk & liquidity premium’
Income tax considerations
Interest payments on municipal bonds are exempt from federal income taxes.

Investors can earn more on Municipal bonds after taxes, so they are willing to hold the riskier and less liquid
municipal bond even though it has a lower interest rate than the Treasury bond.

Interest Rates on Municipal and Treasury Bonds

Tax-free status shifts the demand for Municipal bonds to the right. And shifts the demand for Treasury bonds
to the left. Thus municipal bonds end up with a higher price and a lower interest rate than on Treasury bonds.

Summary of Risk Structure of Interest Rate:

1. As the bond’s default risk increases, the risk premium on that bond rises,
2. Greater liquidity of Treasury bonds leads to lower interest rates than those on less liquid bonds
3. If a bond has a favorable tax treatment, its interest rates will be lower

The Term Structure of Interest Rate:

Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time
remaining to maturity is different.

Yield curve:
A plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations

May have different shapes:

1. Upward-sloping (normal): long-term rates are above short-term rates
2. Flat: short- and long-term rates are the same
3. Downward-sloping (Inverted): long-term rates are below short-term rates

Why yield curves take on different shapes at different times?

Facts for which yield curves take on different shapes at different times:
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when
short-term interest rates are high, yield curves are more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.

Three Theories to Explain the Three Facts

1. Expectations theory explains the first two facts but not the third
2. Segmented markets theory explains fact three but not the first two
3. Liquidity premium theory combines the two theories to explain all three facts
Expectation Theory:
Propositions:
1. The interest rate on a long-term bond will equal an average of the short-term interest rates that people
expect to occur over the life of the long-term bond

2. Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a
bond if its expected return is less than that of another bond with a different maturity

3. Bond holders consider bonds with different maturities to be perfect substitutes.

Skipped other theories:

The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory:

Because the liquidity premium is always positive and grows as the term to maturity increases, the yield curve
implied by the liquidity premium and preferred habitat theories is always above the yield curve implied by the
expectations theory and has a steeper slope. For simplicity, the yield curve implied by the expectations theory
shown here assumes unchanging future one-year interest rates.

1. Yield curve in expectations theory is drawn under the assumed scenario of unchanging future one-year
interest rates.
2. As liquidity premium is always positive, and grows as the term to maturity increases, the yield curve in
LP & PH theories is always above the yield curve in Exp. Theory, and has a steeper slope.

Yield Curves and the Market’s Expectations of Future Short-Term Interest Rates According to the Liquidity
Premium (Preferred Habitat) Theory

A steeply rising yield curve, as in panel (a), indicates that short-term interest rates are expected to rise in the
future. A moderately steep yield curve, as in panel (b), indicates that short-term interest rates are not expected to
rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall
moderately in the future. Finally, an inverted yield curve, as in panel (d), indicates that short-term interest rates
are expected to fall sharply in the future.
 CHAPTER 15: THE MONEY PROCESS

Money Supply:
The total amount of money in circulation, or in existence, in a country.
Components of money supply:
1. Currency Outside banks
2. Deposits of Financial Institutions with Bangladesh Bank
3. Demand Deposits with Financial Institutions
4. Time Deposits with Financial Institutions
5. Money Supply (M1) (1+2+3)
6. Money Supply(M2) (4+5)
Movements in the money supply affect interest rates and the overall health of the economy.

“Three Players” that influence the money supply:

1. Central bank (Bangladesh Bank)- The government agency that oversees the banking system and is
responsible for the conduct of monetary policy.
2. Banks (depository institutions; financial intermediaries): the financial intermediaries that accept
deposits from individuals and institutions and make loans: commercial banks, savings and loan
associations, mutual savings banks, and credit unions
3. Depositors (individuals and institutions): individuals and institutions that hold deposits in banks
4. Borrowers (individuals and institutions): individuals and institutions that borrow from banks

Balance Sheet of Bangladesh Bank:

Bangladesh Bank

Assets Liabilities

Government securities Currency in circulation

Discount loans Reserves

Monetary Liabilities
1. Currency in circulation—in the hands of the public
2. Reserves—bank deposits at the Fed and vault cash in banks
Monetary Assets
1. Government securities—holdings by the Fed that affect money supply and earn interest
2. Discount loans—provide loans to banks and earn the discount rate (the interest rate that Fed charges
banks for these loans)

Monetary Base (MB):

The sum of monetary liabilities (currency (C) in circulation and reserves (R)) is called the monetary base.
Changes in the monetary base usually lead to increases in money supply that are larger than the changes in the
monetary base. As such, monetary base is called high powered money.

So, MB= C+R

Control Over Monetary Base:

1. Open Market Operation
a) Open Market Purchase:
Suppose the BB purchases $100 million of bonds from a primary dealer. The banking system’s
Treasury account after this transaction is:
Banking System
Assets Liabilities
Securities -$100M
Reserves +$100M

The effect on Balance Sheet of BB:

BB Balance Sheet
Assets Liabilities
Securities +$100M Reserves +$100M
 b) Open Market Sale:
If BB conducts an open market sale of $100 million of bonds to a primary dealer
The effect on Balance Sheet of BB:
BB Balance Sheet
Assets Liabilities
Securities -$100M Reserves -$100M

The effect of OMO on Reserve depends on whether the bond-proceeds are kept in currency or in
deposits:
i. If kept in currency, the OMO has no effect on Reserve
ii. If kept as deposits, reserve increase by the amount of the OMO
2. Extension of Discount Loans to Financial Institutions:
If BB makes a $100 million loan to the bank:
Banking System T-Account BB Balance Sheet
Assets Liabilities Assets Liabilities
Reserves +$100M Loans from BB +$100M Loans to Bank +$100M Reserves +$100M

If Bank pays the loan of $100 million loan:

Banking System T-Account BB Balance Sheet
Assets Liabilities Assets Liabilities
Reserves -$100M Loans from BB -$100M Loans to Bank -$100M Reserves -$100M

3. Other factors (Float/Treasury Deposits)

Central Bank’s Control over Monetary Base

Monetary base can be split into two components:
1. Non-borrowed MB(MBn): Under BB’s control through OMO
2. Borrowed reserves (BR): Less tightly controlled through discount loan

The non- borrowed monetary base is formally defined as the monetary base minus borrowings from the Fed,
which are referred to as borrowed reserves:
MBn =MB-BR
where MBn = nonborrowed monetary base
MB = monetary base
BR = borrowed reserves from the Fed

Deposit Creation:
When the BB supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this
amount—a process called multiple deposit creation.

Deposit Creation: Single Bank

Suppose the BB purchases $100 million of bonds from a primary dealer. The banking system’s Treasury account
after this transaction is:
Single Bank
Assets Liabilities
Securities -$100M
Reserves +$100M
Now bank finds that its additional/excess reserves have risen by $100 million. Let’s say the bank decides to make
a loan equal in amount to the $100 million rise in excess reserves. When the bank makes the loan, it sets up a
checking account for the borrower and puts the proceeds of the loan into this account. In this way, the bank alters
its balance sheet by increasing its liabilities with $100 million of checkable deposits and at the same time
increasing its assets with the $100 million loan. The resulting T-account looks like this:
Single Bank
Assets Liabilities
Securities -$100M Checkable Deposits $100M
Reserves +$100M
Loans +$100M
But the Customer writes checks and the Bank will not have reserves. The resulting T-account looks like this:
Single Bank
Assets Liabilities
Securities -$100M
Loans +$100M

Deposit Creation: Banking System

Assume that the $100 million of deposits created by Single Bank’s loan is deposited at Bank A
Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable deposits +$100 Reserves +$10 Checkable deposits +$100

Loans +$90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +$90 Checkable deposits +$90 Reserves +$9 Checkable deposits +$90

Loans +$81

Following the same reasoning, if all banks make loans for the full amount of their excess reserves, further
increments in checkable deposits will continue (at Banks C, D, E, and so on. Therefore, the total increase in
deposits from the initial $100 increase in reserves will be $1,000 million: The increase is tenfold, the reciprocal of
the 10% (0.10) reserve requirement.

The procedure of eliminating excess reserves by loaning them out continues until the banking system (First
Single Bank and Banks A, B, C, D, and so on) has made $1,000 million of loans and created $1,000 million of
deposits. In this way, $100 million of reserves supports $1,000 million (ten times the quantity) of deposits.

Formula for Multiple Deposit Creation:

Assumptions: Banks do not hold excess reserves

!
∆D = " 𝑥∆R

∆D = change in total checkable deposits in the banking system

r = required reserve ratio (0.10 in the example)
∆R = change in reserves for the banking system ($100 million in the example)

For example:
Assume that the $100 million of deposits created by Single Bank’s loan is deposited at Bank A. The required
reserve ratio (r) is 10%.

Deposit Creation will be,

!
∆D = #.!# X 100=1000

Critique of the Simple Model

1. Holding cash stops the process
2. Banks may not use all of their excess reserves to buy securities or make loans
Money Multiplier:
Money Multiplier, denoted by m, which tells us how much the money supply changes for a given change in the
monetary base. The relationship between the money supply M, the money multiplier, and the monetary base is
described by the following equation:
M = m * MB

Formula for Money Multiplier:

!%&
m="%&%'

Here, Reserve Ratio= r

()&'** ,'*'"-'*
Excess Reserve Ratio=e=./'&0123' 4'56*78*
.9""':&; 7: .7"&931876:
Currency Ratio=c= ./'&0123' 4'56*78*

For example
rr = required reserve ratio = 0.10
C = currency in circulation = $1,200 billion
D = checkable deposits = $1,600 billion
ER=Excess Reserve=$2500 billion
Find money multiplier.

Solution:

Here, M = money supply (M1) = C + D = $2,800 billion

$!=##2
So, c=$!>##2=0.75

$=?##2
e=$!>##2=1.56

!%#.@?
The resulting value of the money multiplier is, m=#.!#%#.@?%!.?>=0.73

NB: deposits undergo multiple expansion, currency does not

Factors that determine the money supply/money multiplier:

1. Changes in the Nonborrowed Monetary Base, MBn
The money supply is positively related to the nonborrowed monetary base MBn.
2. Changes in Borrowed Reserves, BR, from the BB
The money supply is positively related to the level of borrowed reserves, BR, from the BB.
3. Changes in the required reserve ratio r
The money multiplier and the money supply are negatively related to r
4. Changes in the currency ratio c
The money multiplier and the money supply are negatively related to c
5. Changes in the excess reserves ratio e
The money multiplier and the money supply are negatively related to the excess reserves ratio e
However reserves ratio e is negatively related to the market interest rate and positively related to
expected deposit outflows
 CHAPTER 16: TOOLS OF MONETARY POLICY

Monetray Policy:
Monetary policy refers to systematic actions taken by a central bank
- affecting money supply, interest rates and exchange rate,
- in order to influence inflation
- to ensure economic growth
- through achieving high output growth and low unemployment.

Tools of Monetary Policy:

1. Open market operations: Affect the quantity of reserves and the monetary base
2. Changes in the discount rate: Affect interest rates and the monetary base by influencing the quantity of
discount loans
3. Changes in reserve requirements: Affect the money multiplier

How Changes in the Tools of Monetary Policy Affect the Call Money Rate:
Call money rate is the interest rate on overnight loans of reserves from one bank to another. Changes in the four
tools of monetary policy affect the market for reserves and the equilibrium call money rate.

1. Open market operations:

a) An open market purchase leads to a greater quantity of reserves supplied because of the higher
amount of non-borrowed reserves, which rises from R1n to R2n.
b) An open market purchase therefore shifts the supply curve to the right from Rs1 to Rs2 and
moves the equilibrium from point 1 to point 2, lowering the call money rate from i1ff to i2ff.

c) Similarly, an open market sale decreases the quantity of reserves supplied, shifts the
supply curve to the left and causes the iff to rise.
d) The result is that an open market purchase causes the call money rate (iff) to fall,
whereas an open market sale causes the call money rate (iff) to rise.
2. Changes in the discount rate:
a) The effect of a discount rate change depends on whether the demand curve intersects the supply
curve in its vertical section versus its flat section.
b) Panel (a) shows what happens if the intersection occurs at the vertical section of the supply curve:
- In this case, when the discount rate (id) is lowered by the Bangladesh Bank from i1d to i2d,
the vertical section of the supply curve where there is no discount lending just shortens,
as in Rs2, while the intersection of the supply and demand curve remains at the same
point (Point 1).
- Thus, in this case there is no change in the equilibrium call money rate (iff), which remains
at i1ff.
- So, there is no discount lending.
c) In panel (b), when the discount rate is lowered by the Bangladesh Bank from i1d to i2d, the flat
section of the supply curve Rs2 falls, and the equilibrium call money rate falls from i1ff to i2ff as
borrowed reserves increase. So, there is some discount lending.
d) Bangladesh Bank usually keeps the discount rate above its target for the call money rate—the
conclusion is that: most changes in the discount rate have no effect on the call money rate.

3. Changes in reserve requirements:

When the required reserve ratio increases, required reserves increase and hence the quantity of reserves
demanded increases for any given interest rate.
Thus, a rise in required reserve ratio.
• shifts the demand curve to the right from Rd1 to Rd2 in,
• moves the equilibrium from point 1 to point 2, and
• in turn, raises the call money rate from i1ff to i1ff.
• The result is that, when the BB raises reserve requirements, the call money rate (iff) rises.