ECON 311 1st Edition Lecture 6 Outline of Last Lecture I Theory of Asset Demand II A Model The Market for Bonds III Increases and Decreases in Bond Demand and Supply Outline of Current Lecture I Bond Markets II Two Applications of the Bond Market Model III Liquidity Preference Model IV Effects of an Increase in Money Supply Current Lecture Chapter 4 The Behavior of Interest Rates I Bond Markets EX Suppose stock prices become more volatile what will happen to the bond market P Bond Price B S i2 P2 i1 P1 B2D B1D B quantity of bonds If stock prices go up the demand for bonds D will increase B2 causing the price of bonds to rise and the interest rate to fall II Two Applications of the Bond Market Model 1 Fisher Effect What happens to interest rates when expected inflation increases These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Expected inflation decreases demand for bonds B2D and increases the supply of bonds B2S Increases in expected inflation decrease bond prices and increase interest rates 2 Interest and P Bond Price B1 S Rates the B2 S i1 P1 i2 P2 B1 D B2D B quantity of bonds Business Cycle Are interest rates Pro Cyclical or Counter Cyclical Assume That there is a recession so the GDP falls indicating a decrease in wealth The decrease in bond demand B2D pushes interest rates up and bond prices down and the decrease in the supply of bonds B2S pushes interest rates down making the model ambiguous So we ask Which curve shifts more Using collected data graphs in book we can conclude that during an expansion interest rates rise and during a recession interest rates fall Making interest rates a PRO CYCLICAL variable This means that the B2 P Bond Price effect on the S B1 supply of bonds S usually has a larger effect than the effect on demand i1 P1 i2 P2 III Liquidity Preference Model B1 D B2D B quantity of bonds Assumptions Wealth can either be held in bonds which accumulate interest or in money which does not accumulate interest Demand for Money If money doesn t pay interest then interest is the opportunity cost of holding money If you expect interest rates to fall then you re expecting bond prices to rise so you d want to hold less money and more bonds This assumes that there is a normal interest rate that the market is always moving towards Supply for Money Determined Central Bank Interest Rate by the MD money demand curve Quantity of money Interest Rate Equilibrium for Money MS money supply curve Quantity of money Interest Rate Factors that Shift the M S i 1 Changes in income a Increase in money Demand and Supply of Money income MD increases the demand for Quantity of Money Demanded i When you have more income you want to buy more goods therefore you need more money Liquidity is important here 2 Changes in Price Level a Increase in price level increase the demand for money i When you want to continue to buy the same good but the price has increased you need more money 3 The Central Bank can shift the money supply curve Impact of an INCREASE in money supply The interest rate falls when money supply increases This is called the LIQUIDITY EFFECT of an increase in Money supply Page 99 of the textbook has three graphs of the effect this has in a real world situation that includes the effects of Income Price Level and Inflation effects IV Effects of an Increase in Money Supply 1 Interest Rate Liquidity if i money 1 supply i 2 Effect MS money supply curve Quantity of money increases then interest rates fall 2 Income Effect if money supply increases the income rises which cause interest rates to rise 3 Price Level Effect if money supply increases the price of goods rise which cause demand form money to increase which raises interest rates 4 Expected Inflation Effect if money supply increases inflation expectations increase which lowers bond prices which raises interest rates Fisher Effect The most common effects of an increase in money supply are show on page 99 in the middle graph where there is first a decrease in the interest rate during the liquidity effect and then the interest rate rises to higher than its previous rate because of the other effects P Factors that increase the demand for bonds