Peter N. Ireland Department of Economics Boston College irelandp@bc.edu http://www2.bc.edu/~irelandp/ec261.html

Chapter 5: The Behavior of Interest Rates

1. Loanable Funds Framework Demand Curve Supply Curve Market Equilibrium 2. Changes in Equilibrium Interest Rates Shifts in Demand Shifts in Supply Example: Interest Rates and the Business Cycle By studying Mishkin’s Chapter 4, we learned how interest rates could be measured for a wide variety of credit market instruments. But what economic factors serve to determine these interest rates in the ﬁrst place? To answer this question, we will now imagine for simplicity that there is just one type of bond and hence one interest rate for the economy as a whole. The most important lesson from Chapter 4 is that bond prices and interest rates are negatively related. This fact implies that if we can understand what makes bond prices rise and fall, then we can also explain what makes interest rates change. In particular, any economic factor that makes bond prices rise will simultaneously cause interest rates to fall; and any economic factor that makes bond prices fall will simultaneously cause interest rates to rise. Thus, Chapter 5 develops a framework–called the “loanable funds” framework–that can be used to analyze how bond prices and interest rates are determined and why bond prices and interest rates might change over time. The beauty of this loanable funds framework is that it is based on the same kind of demand and supply analysis that is used in basic microeconomics. 1

The chapter shows how demand and supply curves for bonds can be derive and then reviews how the intersection of those curves determines the equilibrium bond price–and hence the equilibrium interest rate. Using this demand-and-supply framework, the chapter goes on to identify factors that change the equilibrium interest rate either by shifting the demand curve or shifting the supply curve. And, ﬁnally, the chapter presents an example in which this demand-and-supply framework is used to analyze how interest rates behave over the business cycle.

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Loanable Funds Framework

What economic factors serve to determine the behavior of interest rates? We can use the loanable funds framework to answer this question. The loanable funds framework involves applying basic demand-and-supply analysis to the bond market, drawing on our previous insight: that bond prices and interest rates are negatively related.

1.1

Demand Curve

To make things concrete and simple, let’s suppose that the only credit market instrument in the economy is a one-year discount bond with face value of $1,000. We already know that if P = today’s bond price F = face value of the bond ($1000 in this case) i = yield to maturity then i= F −P $1000 − P = . P P

Next, suppose that the price of the bond today is P = $950. Then i= $1000 − $950 $50 = = 0.053 = 5.3%. $950 $950

Again to make things concrete, suppose that at this price, the quantity of bonds demanded is $100 billion. 2

Now suppose that the price of the bond today is P = $900. Then i= $1000 − $900 $100 = = 0.111 = 11.1%. $900 $900

As the interest rate on the bond goes up, it seems natural to assume that the quantity demanded will rise. So suppose that at this price, the quantity demanded is $200 billion. We can plot these points on a graph like the one shown in Mishkin’s Figure 1 (p.89). The demand curve slopes down because: As the interest rate rises, the bond becomes more attractive to investors. As the bond price falls, investors demand more bonds.

1.2

Supply Curve

Now let’s consider the properties of the demand curve for bonds. As before, suppose ﬁrst that the price of the bond today is P = $950, so that the interest rate is i = 5.3%. Suppose that at this price, the quantity of bonds supplied is $500 billion. Now suppose that the price of the bond today is P = $900, so that the interest rate...