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Transcript of Chapter Four
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Copyright © 2000 Addison Wesley Longman Slide #4-1
Chapter Four
BEHAVIOR OF INTEREST RATES
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Copyright © 2000 Addison Wesley Longman Slide #4-2
Determinants of Asset Demand
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Copyright © 2000 Addison Wesley Longman Slide #4-3
Benefits of Diversification
1. Diversification almost always beneficial to risk-averse investor
2. Less returns of securities move together, greater is risk reduction from diversification
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Copyright © 2000 Addison Wesley Longman Slide #4-4
Derivation of Demand Curvei = RETe = (F - P)
PPoint A:
P = $950
i = ($1000 - $950) = .053 = 5.3% $950
Bd = 100
Point B:P = $900i = ($1000 - $900) = .111 = 11.1%
$900
Bd = 200
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Copyright © 2000 Addison Wesley Longman Slide #4-5
Point C: P = $850 i = 17.6% Bd = 300
Point D: P = $800 i = 25.0% Bd = 400
Point E: P = $750 i = 33.0% Bd = 500
Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E.
Has usual downward slope
Derivation of Demand Curve
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Copyright © 2000 Addison Wesley Longman Slide #4-6
Supply and
Demand Analysis
of the Bond
Market
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Copyright © 2000 Addison Wesley Longman Slide #4-7
Derivation of Supply Curve
Point F: P = $750 i = 33.0% Bs = 100
Point G: P = $800 i = 25.0% Bs = 200
Point C: P = $850 i = 17.6% Bs = 300
Point H: P = $900 i = 11.1% Bs = 400
Point I: P = $950 i = 5.3% Bs = 500
Supply Curve is Bs that connects points F, G, C, H, I, and has upward slope
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Copyright © 2000 Addison Wesley Longman Slide #4-8
1. Occurs when Bd = Bs, at P* = 850, i* = 17.6%
2. When P = $950, i = 5.3%, Bs > Bd (excess supply): P to P*, i to i*
3. When P = $750, i = 33.0, Bd > Bs (excess demand): P to P*, i to i*
Market Equilibrium
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Copyright © 2000 Addison Wesley Longman Slide #4-9
Loanable Funds Terminology
1. Demand for bonds = supply of loanable funds
2. Supply of bonds = demand for loanable funds
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Copyright © 2000 Addison Wesley Longman Slide #4-10
Shifts in the Demand Curve
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Copyright © 2000 Addison Wesley Longman Slide #4-11
How Factors Shift the Demand Curve1. Wealth
A. Economy , wealth , Bd , Bd shifts out to right
2. Expected ReturnA. i in future, RETe for long-term bonds , Bd shifts out to
right
B. πe , relative RETe , Bd shifts out to right
3. RiskA. Risk of bonds , Bd , Bd shifts out to right
B. Risk of other assets , Bd , Bd shifts out to right
4. LiquidityA. Liquidity of bonds , Bd , Bd shifts out to right
B. Liquidity of other assets , Bd ,Bd shifts out to right
(RETe)指現在的預期 1年持有報酬率指預期未來YTM會下降
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Copyright © 2000 Addison Wesley Longman Slide #4-12
Factors that Shift
Demand Curve
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Copyright © 2000 Addison Wesley Longman Slide #4-13
Shifts in the Supply Curve1. Profitability of
Investment Opportunities
• Business cycle expansion, investment opportunities , Bs , Bs shifts out to right
2. Expected Inflation
• πe , Bs , Bs shifts out to right
3. Government Activities
• Deficits , Bs , Bs shifts out to right
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Copyright © 2000 Addison Wesley Longman Slide #4-14
Factors that Shift Supply Curve
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Copyright © 2000 Addison Wesley Longman Slide #4-15
Changes in π e: the Fisher Effect
If π e 1. Relative
RETe , Bd shifts in to left
2. Bs , Bs shifts out to right
3. P , i
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Copyright © 2000 Addison Wesley Longman Slide #4-16
Evidence on the Fisher Effect in the United States
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Copyright © 2000 Addison Wesley Longman Slide #4-17
Business Cycle Expansion
1. Wealth , Bd , Bd shifts out to right
2. Investment , Bs , Bs shifts right
3. If Bs shifts more than Bd then P , i
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Copyright © 2000 Addison Wesley Longman Slide #4-18
Evidence on Business Cycles and Interest Rates
不景氣
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Copyright © 2000 Addison Wesley Longman Slide #4-19
Relation of Liquidity Preference Framework to Loanable Funds
Keynes’s Major AssumptionTwo categories of assets in wealth
1. money
2. bonds
1. Thus: Ms + Bs = Wealth
2. Budget constraint: Bd + Md = Wealth
3. Therefore: Ms + Bs = Bd + Md
4. Subtracting Md and Bs from both sides:
Ms - Md = Bd - Bs
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Copyright © 2000 Addison Wesley Longman Slide #4-20
Money Market Equilibrium 5. Occurs when Md = Ms
6. Then Md - Ms = 0 which implies that Bd - Bs = 0, so that Bd = Bs and bond market is also in equilibrium
Relation of Liquidity Preference Framework to Loanable Funds
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Copyright © 2000 Addison Wesley Longman Slide #4-21
Relation of Liquidity Preference Framework to Loanable Funds
1. Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money in liquidity preference framework
2. Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects from changes in expected returns on real assets
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Copyright © 2000 Addison Wesley Longman Slide #4-22
Liquidity Preference Analysis
Derivation of Demand Curve 1. Keynes assumed money has i = 0
2. As i , relative RETe on money (equivalently, opportunity cost of money ) Md
3. Demand curve for money has usual downward slope
Derivation of Supply curve 1. Assume that central bank controls Ms and is a
fixed amount 2. Ms curve is vertical line
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Copyright © 2000 Addison Wesley Longman Slide #4-23
Liquidity Preference Analysis
Market Equilibrium1. Occurs when Md = Ms, at i* = 15%2. If i = 25%, Ms > Md (excess supply): Price of
bonds , i to i* = 15%3. If i =5%, Md > Ms (excess demand): Price of
bonds , i to i* = 15%
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Copyright © 2000 Addison Wesley Longman Slide #4-24
Money Market
Equilibrium
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Copyright © 2000 Addison Wesley Longman Slide #4-25
Rise in Income 1. Income ,
Md , Md shifts out to right
2. Ms unchanged
3. i* rises from i1 to i2
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Copyright © 2000 Addison Wesley Longman Slide #4-26
Rise in Price Level 1. Price level
, Md , Md shifts to right
2. Ms unchanged
3. i* rises from i1 to i2
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Copyright © 2000 Addison Wesley Longman Slide #4-27
Rise in Money Supply
1. Ms , Ms shifts out to right
2. Md unchanged
3. i* falls from i1 to i2
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Copyright © 2000 Addison Wesley Longman Slide #4-28
Factors that Shift Money Demand and Supply Curves
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Copyright © 2000 Addison Wesley Longman Slide #4-29
Money and Interest Rates
Effects of money on interest rates1. Liquidity Effect
Ms , Ms shifts right, i
2. Income EffectMs , Income , Md , Md shifts right, i
3. Price Level EffectMs , Price level , Md , Md shifts right, i
4. Expected Inflation EffectMs , πe , Bd , Bs , Fisher effect, i
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Copyright © 2000 Addison Wesley Longman Slide #4-30
Effect of higher rate of money growth on interest rates is ambiguous- Because income, price level and expected inflation
effects work in opposite direction of liquidity effect
Money and Interest Rates
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Copyright © 2000 Addison Wesley Longman Slide #4-31
Does Higher Money Growth Lower
Interest Rates?
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Copyright © 2000 Addison Wesley Longman Slide #4-32
Evidence on Money Growth and Interest Rates
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Copyright © 2000 Addison Wesley Longman Slide #4-33
Profiting from Interest-Rate Forecasts
Methods for Forecasting1. Loanable funds: use Flow of Funds Accounts and
judgement
2. Econometric Models: large in scale, use liquidity preference
Make decisions about assets to hold1. Forecast i , buy long bonds
2. Forecast i , buy short bonds
Make decisions about how to borrow1. Forecast i , borrow short
2. Forecast i , borrow long
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Copyright © 2000 Addison Wesley Longman Slide #4-34
Supply and Demand in Gold Market
Deriving Demand Curve
1. Pet+1 is held constant
2. Pt , ge , RETe Gd 3. Demand curve is downward sloping
Deriving Supply Curve
1. Pt , more production, Gs 2. Supply curve is upward sloping
e
t
te1te gP
PPRET
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Copyright © 2000 Addison Wesley Longman Slide #4-35
Supply and Demand in Gold Market
Market Equilibrium1. Gd = Gs
2. If Pt > P* = P1, Gs > Gd, Pt to P*
3. If Pt < P* = P1, Gs < Gd, Pt to P*
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Copyright © 2000 Addison Wesley Longman Slide #4-36
Changes in Equilibrium
Factors that Shift Demand Curve for Gold1. Wealth
2. Expected return on gold relative to alternative assets
3. Riskiness of gold relative to alternative assets
4. Liquidity of gold relative to alternative assets
Factors that Shift Supply Curve for Gold1. Technology of mining
2. Government sales of gold
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Copyright © 2000 Addison Wesley Longman Slide #4-37
Response of Gold Market to a Change in πe If πe
1. πe , Pet+1 ;
at given Pt, ge Gd Gd shifts right
2. Go to point 2; Pt
3. Price of gold positively related to πe
4. Gold price is barometer of π-pressure