Interest Rates and Bond Prices Interest the fee that borrowers pay to lenders for the use of their funds Firms and governments borrow funds by issuing bonds and they pay interest to the lenders that purchase the bonds Households also borrow either directly for banks and nance companies or by taking out mortgages Bonds rst they are issued with a face value typically in denominations of 1 000 Second they come with maturity date which is e date the borrower agrees to pay the lender the face value of the bond Third there is xed payment of speci ed amount that is paid to bond holder each year coupon The bond market directly determines price of bonds not interest rates Given a bond s market determined price it s face value maturity and coupon the interest rate or yield on that bond can be calculated Interest rates are indirectly determined by bond market The Demand for Money Concerned with how much of your nancial assets you want to hold in the form of money which does not earn interest versus how much you want to hold in interest bearing securities such as bonds The Transaction Motive The main reason that people hold money to buy things Simplifying assumptions There are only two kinds of assets available to households bonds and money by bonds we mean interest bearing securities of all kinds Income for a typical household is bunched up It arrives once a month at the beginning of the month Spending is spread over time at a completely uniform rate throughout the month Nonsynchronization of income and spending the mismatch between the timing of money in ow to the household and the timing of money out ow for household expenses Giving up interest on funds you could be earning if held some funds in interest bearing bonds Jim decides to deposit entire paycheck of 1 200 into his checking account He spends his money at a constant 40 a day 40 per day times 30 days per month 1 200 His average balance is just his starting balance plus his ending balance divided by 2 1 200 0 2 600 Give himself more interest Jim could put half his paycheck into checking account and buy bond with other half By doing this he would run out of money in checking account halfway through month at spending rate of 40 a day his initial deposit of 600 would only last 15 days Jim would have to sell bond halfway through month and deposit the 600 from the sale of the bond in checking account to pay bills for second half of month Demand curve for money balances downward sloping curve higher the interest rate less money is demanded The Speculation Motive One reason for holding bonds instead of money because the market price of interest bearing bonds is inversely related to the interest rate investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall When market interest rates are lower than normal you may expect the to rise in the future Rising interest rates will bring about a decline in the price of existing bonds Thus when interest rates are low it is a good time to be holding money and not bonds not only is the opportunity cost of holding cash balances low but also there is a speculative motive for holding a larger amount of money The Total Demand for Money Total quantity of money demanded in economy is the sum of the demand for checking account balances and cash by both households and rms Like households rms must manage their money payrolls to meet and purchases to make they receive cash and checks from sales and many rms that deal with the public must make change they need cash in cash register The Effect of Nominal Income on the Demand for Mone Demand for money curve shifts out when nominal income increases Demand for money depends negatively on interest rate r and positively on real income Y and the price level P The Equilibrium Interest Rate Supply and Demand in the Money Market Equilibrium exists in money market when supply of money is equal to demand for money and thus when supply of bonds is equal for demand of bonds When the interest rate rises there is an excess supply of money and excess demand for bonds while when the interest rate declines there is an excess demand for money and excess supply Changing the Money Supply to Affect Interest Rate Suppose current interest rate is 7 percent and the Fed wants to reduce the interest rate It would expand money supply To expand money supply Fed can reduce reserve requirement cut the discount rate or buy u s Gov securities on the open market or make more loans As money supply expands supply of bonds is decreasing which drives up prices of bonds The new equilibrium interest rate would be smaller If Fed wanted to increase interest rate it would contract money supply Contract money supply by increasing reserve requirement raising discount rate or selling u s gov securities Supply of money curve would shift to left and equilibrium interest rate would rise Increases in P x Y and Shifts in Money Demand Curve Demand for money depends on both interest rate r and nominal income P x Y Increase in P x Y shifts money demand curve to the right and result is increase in equilibrium level of interest rate Decrease in P x Y would shift money demand curve to the left and equilibrium interest rate would fall Remember that P x Y can change because the price level P changes or because real income Y changes
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