ECO 531- CHAPTER 4

THE BEHAVIOR OF INTEREST

RATE
OBJECTIVES OF THE LESSON
 Interest Rates, Rate of Returns and Price of
Bond
 Real and Nominal Interest Rates
 Theories on the Determination of Interest
Rates
(i) Classical Model (bond market)
(ii) Keynesian Model (money market)
 INTEREST RATE
 Important variable in the economy.
 Are reported almost daily by the
news media, because it directly
affect our everyday lives and have
important consequences for the
health of the economy.
For the borrower, interest rate is a
 It affect personal decisions such as payment for obtaining credit (loan) or
the cost of borrowing for rental of
whether to consume or save, funds, expressed as a percentage per
whether to buy a house, and year.
whether to purchase bonds or put
funds into savings account. For the lender, it is the amount of
funds, that they receive when they
 Interest rates play important role in extend credit. It is a reward for
delaying their current consumption.
our life and in the general economy.
MEASURING INTEREST RATE
 Yield to maturity (YTM) is the most accurate measure of
interest rate.
 YTM also refer to the interest rate that equates the present
value of cash flow payments received from a debt instrument
with its value today.
 i.e we are equating today’s value of the debt instrument
with the present value of all of its future cash flow
payments.
 YTM is also called the internal rate of return.
 Bond’s i/rate does not necessarily indicate how good an
investment the bond is, because what the bond earns (its
rate of return) does not necessarily equal its interest rate.
COUPON BOND
 To know the concept of YTM, we can use coupon bond as an example.
 A coupon payment on a bond is a periodic interest payment that the
bondholder receives during the time between when the bond is issued
and when it matures.
 Its identified by four pieces of information:
 First is the bond’s face value
 Second is the corporation or government agency that issues the bond
- capital market instruments such as Treasury bonds and notes and
Corporate bonds
 Third is the maturity date of the bond
 Fourth is the bond’s coupon rate - which is the dollar amount of the
yearly coupon payment expressed as a percentage of the face value
of the bond.
COUPON BOND

In our example: the coupon bond has a yearly

coupon payment of $100 and a face value of
$1000.

The coupon rate is then $100/$1000 = 0.10 or 10%.

It pays the owner of the bond a fixed interest

payment - coupon payment - every year until
maturity date, when a specified final amount - face
value/par value - is repaid.
PRICE OF BOND
 Price of bond and YTM are negatively related.
 When the interest rate rises, the price of the bond falls.

Price of bond ($) Yield to maturity (%)

1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81

 When the coupon bond is priced at its face value, the YTM equals the coupon
rate.
 The YTM is greater than the coupon rate when the bond price is below its
face value.
 The price of a coupon bond and the YTM are negatively related; that is, as
the YTM rises, the price of the bond falls. As the YTM falls, the price of the
bond rises.
 RATES OF RETURN (ROR)
 ROR are basically return on investment or reward of taking risks. Ex.
return on stocks, bonds, saving, etc.
 ROR is defined as a payments to the owner of a security (dividend paid)
plus the change in the value of the security (appreciation in value),
expressed as a fraction of its purchase price.
 i.e - use the same example as coupon bond - $1000 with 10% - held for
one year, and then sold for $1200 (decided to sell at higher value
@1200), the payments to the owner are the yearly coupon payments of
$100.
 ::The change in the bond’s value is $1200 - $1000 = $200.
 Adding this value together and expressing them as a fraction of the
purchase price of $1000 gives us the one-year holding-period return for
this bond:
ROR is defined
 $200 + $100 = 0.30 = 30% as a payments to
$1000 the owner plus
the change in its
value.
 THE DISTINCTION BETWEEN
NOMINAL AND
REAL INTEREST RATE
Nominal
 So far in our discussion of i/rate, we have ignored the effects of
inflation on the cost of borrowing.
 What we up to this point have been calling the i/rate makes no
allowance for inflation – more precisely referred to as the nominal
i/rate.
 Nominal rate is the rate of interest that is accrued at some time in
the future - simply ‘returns’.
 It is the rate of exchange between RM now and RM in the future.
 For ex., if the nominal interest rate is 10% per annum, then a sum of It ignores
RM10 borrowed this year, is payable for a sum of RM11 next year. the
effects of
inflation.
Real
 The interest rate that is adjusted by subtracting
expected changes in the price level (inflation), so
that it more accurately reflects the true cost of
borrowing.
 Real = Nominal - Expected Inflation
 If the nominal interest rate is 10% and the inflation
rate is 3%, the real interest rate is really 7%.
 From the Fisher, a higher expected inflation rate
would reduce the real interest rate.
 When the real interest rate is low, there are
greater incentives to borrow and fewer incentives
to lend.
• Real i/rate which reflects the real cost
of borrowing is likely to be a better
indicator of the incentives to borrow
and lend.

• Be a better guide to how people will

respond to what is happening in credit
markets.
DETERMINING THE QUANTITY
DEMANDED OF AN ASSET
 There are 4 factors that we must be considered in holding/ buying
an asset.
❑ Wealth - the total resources owned by the individual, including all
assets. An increase in wealth raises the quantity demanded of an assets.
❑ Expected Return - the return expected over the next period on one asset
relative to alternative assets. Increase in asset’s expected return
relative to that of an alternative asset, raises the quantity demanded of
the assets.
❑ Risk - the degree of uncertainty associated with the return on one asset
relative to alternative assets. If asset’s risk rises relative to that of
alternative assets, quantity demanded will fall.
❑ Liquidity - the ease and speed with which an asset can be turned into
cash relative to alternative assets. The more liquid an assets, the more
desirable it is, the greater will be the quantity demanded.
 THEORY OF ASSET DEMAND
 Holding all other factors constant:
❑ The quantity demanded of an asset is positively related to
wealth
❑ The quantity demanded of an asset is positively related to its
expected return relatives to
alternative assets
❑ The quantity demanded of an asset is negatively related to the
risk of its returns relative to alternative assets
❑ The quantity demanded of an asset is positively related to its
liquidity relative to alternative assets.
 CHANGES IN EQUILIBRIUM
INTEREST RATE
• Interest rate will change if there are changes in demand or
supply curves of loanable fund.

• The factors that influence the demand curve to

shift:
1. Wealth - when economy is growing in business cycle
expansion, wealth is increasing. The quantity of bond
demanded increase. The demand curve will shift to the right.
During recession, income and wealth decreasing. The demand
for bonds declined. The demand curve will shift to the left.
2. Expected returns
i) Expected return on bonds - if people think that interest rate will
be higher in the future (savings), it means that the expected
returns for long-term bonds will be lower. So, the demand for
long-term bond will decrease. The demand curve will shift to the
left.
• In contrast, if the expected returns on bonds increase, bonds
become a more attractive investment. Then the DD for bonds ….
• But this is not the only change in the DD for bonds that occurs
when expected returns rise. Bond DD is also affected by changes
in the……
ii) Expected returns on other assets -
• For example, if investors become more optimistic about business
prospects, expected capital gains on stocks are higher. At the
same time, if the expected return on bonds do not change, DD
for bonds will be reduce. The demand curve will shift to the
left.
iii) Expected Inflation - an increase in the expected
rate of inflations lowers the expected return for
bonds, causing their demand to decline and to shift
demand curve to the left.
• An increase in expected inflation raises expected
future prices of physical assets (houses, cars,
commodities), implying nominal capital gains and
higher expected returns from holding these assets.
• If the expected return on bonds does not change, a
rise in the expected return on physical assets reduces
the expected return on bonds relative to that on
physical assets, causing the DD for bonds to fall and
shift to the left.
3. Risk – if prices of bonds volatile, the riskiness of bond
increase, the bond is less attractive. The demand for bond
decrease and the demand curve shift to the left. If price of
the other asset become volatile, bond is more attractive.
The demand for bond increase and the demand curve shift
to the right.
4. Liquidity – if the bond is easier to sell, the quantity of bond
demanded increased. Increased liquidity of bonds will
increase the demand for bonds and the demand curve will
shift to the right.
5. Costs information – is the cost associated in acquiring
information on bonds, i.e. cost of travelling, research, time
and more importantly is the accuracy of the information.
Increased the cost resulted the demand for bond will be
declined. While, increased information resulted an
increased in the demand for bond.
 The factors that influence the supply
curve to shift:
1. Expected profitability of investment opportunities – if
the investment is profitable, the firms are willing to
borrow in order to finance the investment. The quantity
of bonds supplied increased.
 In an expansion, investment opportunities are expected
to be profitable. Supply of bond increase and the
supply curve shifts to the right.
 If the economy facing recession, the expected
profitable investment are low, supply of bond decrease
and the supply curve shift to the left.
2. Expected inflation – if the expected
inflation increased, the real interest rate
falls. The cost of borrowing decreased. The
supply of bond increase and supply curve shift
to the right.
 But, if the expected inflation decreased, the
real interest rate is higher. The cost of
borrowing increased. It will reduce the supply
of bond and the supply curve shift to the left.
 In other word, an increase in the expected
inflation reduces the value of existing bonds
and raises borrowers’ willingness to supply
bonds at any bond price. Then the SS curve
shifts to the right.
3. Government activities/borrowing – decision
by governments can affect bond prices and
interest rates in the economy. When
government is in deficit, the BNM will issue
bond to finance the deficit.
 The supply of bond increased and the supply
curve shift to the right, reducing the price of
bonds and increasing the interest rate.
 When government have surplus, they will
reduce the supply of bond in market, the
supply curve shift to the left.
4. Business taxation – investment
incentives such as tax subsidies for
investment, increase the profitability
of investment thus increase firm’
willingness to supply bonds and shift
the supply curve to the right.
Conversely, higher tax burdens on the
profits earned by new investment
reduce firms’ willingness to supply
bond and shift the supply curve to the
left.
 MARKET EQUILIBRIUM
 Occurs when the amount that people are willing to
buy (demand/ Bd) equals the amount that people
are willing to sell (supply/ Bs) at a given price.
 When Bd = Bs : the equilibrium; price of bond and
interest rate are determined.
 When Bd > Bs : excess demand ( E>F); price of
bond will rise and interest rate will fall.
 When Bd < Bs : excess supply (I>A); price of bond
will fall and interest rate will rise.
SS&DD IN THE BOND MARKET
AND LOANABLE FUNDS
We can view the buyer (demander) of bonds and the
seller/issuer (supplier) of bonds in 2 ways.
1. Bonds as the “good”.
 In this case, the lender is buying the bond and the
borrower is selling the bond. The amount the lender pays
for the bond is the price of the bond.
2. Funds as the “good”.
▪ In this case, the borrower is the buyer because the
borrower purchases the use of the funds and pays for it
with a promise to repay. The seller is the supplier of the
funds. The price of the funds exchanged is the interest
rate.
SS&DD IN THE BOND MARKET
AND LOANABLE FUNDS

DD SS Price

Bond is the good Lender Borrower Bond price

who buys bond issuing bond

Fund is the good Borrower Lender Interest rate

raising funds supplying funds
 SHIFT IN BOTH DEMAND AND
SUPPLY OF BOND
❑ Changes in expected inflation
❑ Fisher effect: expected inflation rise, the
nominal interest rate also rise (but the real
interest rate fall)

A. Expected Inflation effect - Increase /

Decrease
B. Business cycle effect - Expansion /
Contraction
 A1: INCREASE IN EXPECTED
INFLATION
DD for bond
• Interest rate forecasts pay attention to surveys about any signs
of expected inflation.
• When inflation, lenders realize that at any given bond price (or
interest rate), the expected real return from lending has fallen.
• It lower the expected return for bonds, therefore they decrease
their willingness to hold bonds (lenders reduce their DD for
bonds).
• Causing demand to shift to the left to D1.
• Conclusion: The bond DD curve shifts to the left, in response to
the lower expected return.
 CONT’D..
SS of bond
• Borrowers view the increase in expected inflation
differently.
• For them, at any given bond price (or interest rate), the
real cost of borrowing has fallen.
• As a consequence, the quantity of bonds supplied rises at
any given bond price.
• The bond SS curve shifts to the right to S1.
 Conclusion: The bond SS curve shifts to the right, in
response to the lower cost of borrowing.
 A2: DECREASE IN EXPECTED
INFLATION
DD for bond
 Decrease in expected inflation will increase the
expected return on bonds. The demand for bond
increase and the demand curve shift to the right
to D1.

SS of bond
 If the expected inflation decreased, the real
interest rate is higher, cost of borrowing
increased. The supply of bond falls and the
supply curve shift to the left to S1.
 B1: EXPANSION IN BUSINESS
CYCLE
DD for bond
 Expansions in business cycle increase people’s wealth. Increase in
wealth means that people have a tendency to hold asset.
 The demand for bond increased and the demand curve for bond shift to
the right to D1.

SS of bond
 During the business cycle expansion, aggregate output increase. So,
national income increased. There are many profitable investments. It
will encourage people to borrow and invest.
 The supply of bond increased. The supply curve shifts to the right to S1.

❖ Effect: price of bond falls, interest rate rises.

 B2: CONTRACTION IN
BUSINESS CYCLE
DD for bond
 Business cycle contraction decreased the people’s wealth.
 The demand for bond decrease and the demand curve shift to the
left to D1.

SS of bond
 Contraction in business cycle reduced the aggregate output. There
are many unprofitable projects.
 The supply of bond falls and the supply curve shift to the left to S1

❖ Effect: price of bond rises, interest rate falls (according to theory).

 THE LIQUIDITY PREFERENCE
FRAMEWORK
 The Liquidity Preference Framework by Keynes determined the interest rate
by the intersection of demand and supply of money (in Money Market).
 According to Keynes:

Money demand Money supply Equilibrium r using Md=Ms.

THEORY OF MONEY DEMAND:
KEYNES’ demand for money includes
demand for idle cash (currency and
demand deposits).
3 motives of holding money:
1.Transactionary motive
2.Precautionary motive
3.Speculative motive
1. TRANSACTIONARY MOTIVE
(DMT)
 Very importance motive for consumer expenditures
and business transaction
 Household demand for purchase g&S.
 Firms demand for purchase pf that supply by
Household
 Demand for this motive depends on income level
 As income increase, DMt also increase (+ve
relationship)
2. PRECAUTIONARY MOTIVE
(DMP)
 DD for money also used for saving or for
unpredictable problems in the future.
 Money may used to pay for hospital bill if
accident or use when individual resign from their
work.
 DD for this motive also depends on Yd.
 As income increase, DMp also increase (+ve
relationship)
3. SPECULATIVE MOTIVE
(DMS)
 Individual DD for money for the purpose of speculation.
 They buy share and bond to get the profit
 Speculative motive exist when people choose either want
to hold money without any interest rate or invest it and
get more income.
 People will buy bond when they expect interest rate will
decrease and price increase in the future
 Otherwise, people will sell bond when they expect interest
rate will increase and price decrease in the future.
 So, DMs is depends on interest rate.
 When interest rate is high, DMs will be lower (-ve/inverse
relationship)
FACTORS THAT INFLUENCED
MONEY MARKET:

1.Changes in income
2.Changes in the price level
3.Changes in the money supply
 1. INCOME EFFECT
❑ There were 2 reasons why income would
affect the demand for money.
✔ As an economy expands, income rises, wealth
increases and people will want to hold more money
as a store of value.
✔ As an economy expands, income rises, people will
want to carry out more transactions using money, so
that they will hold more money.
❑ Conclusion: a higher level of income causes
the demand for money to increase and
demand curve shift to the right.
During business cycle expansion,
income is rising. Demand for money
will rise.
Demand curve shift rightward.
Equilibrium interest rate rises from
i1 to i2.
2. PRICE LEVEL EFFECT

• Keynes took the view that people care about the amount of
money they hold in real terms – that is, in terms of the g&s it
can buy.
• When the price level increases, the same nominal quantity of
money is no longer as valuable.
• It cannot be used to purchase as many real goods or services.
• To restore the holdings of money in real terms to its former
level, people will want to hold a greater nominal quantity of
money.
• Conclusion: an increase in the price level causes the demand
for money to increase and the demand curve shift to the
right.
 When the price level rises, the value of money
in terms of what it can purchase is lower.
People will want to hold more money.
 The demand curve for money increase. The
demand curve shifts to the right from Md1 to
Md2.
 The equilibrium interest rate rises from r1 to
r2.
 3. CHANGES IN THE MONEY
SUPPLY

Supply of money is totally controlled by

the central bank, which in Malaysia is
Bank Negara Malaysia.
 The changes in monetary policy
implementation will shift the supply
curve to the left or to the right.
When government implemented
expansionary monetary policy, the
money supply increases.
The supply curve shift to the right from
Ms1 to Ms2.
The equilibrium interest rate falls from
r1 to r2.