Determining Market Interest Rates

Transcription

1 CHAPTER 6 Determining Market Interest Rates Web Site Suggestions: reservegov/releases Presents data on US interest rates The 2000 presidential campaign was dominated by a struggle between George W Bush and Al Gore over what to do with the emerging US budget surplus an event unprecedented in a generation Indeed, the wait for this surplus had been going on for some time As far back as 1994, Washington Post columnist Bob Woodward s book The Agenda, which chronicled US budget planning during 1993, was a best-seller A notable and perhaps surprising theme was the attention that budget planners paid to the bond market (in particular, the market for long-term bonds issued by the US Treasury) The exhaustive debate between the President s political advisors and economic advisors over a deficit reduction package led one political adviser to inquire, How many votes does the *!@ bond market have? The concern over the bond market s votes was practical A rise in bond prices in response to a budget that reduced the deficit would reduce interest rates paid by households, businesses, and the government itself In this chapter, we describe how lending and borrowing decisions produce a supply of and demand for funds in the financial system We show how such decisions affect interest rate determination Using the analysis in Chapter 4, we know that interest rates and bond prices are negatively related; hence explaining movements in bond prices permits us to explain movements in interest rates As in other markets that you studied in your first economics course, the equilibrium price of bonds and the interest rate depend on supply and demand considerations A change in the federal budget deficit is only one of many reasons that market interest rates rise and fall In this chapter, we describe other reasons for the volatility of market interest rates, beginning with an investigation of what determines market interest rates in the first place Supply and Demand in the Bond Market and Loanable Funds The interest rate that prevails in the bond market is determined by the demand for and supply of bonds To see how this interest rate is set, we begin by focusing specifically on the behavior of bond buyers and sellers We restrict our investigation to the quantity of bonds in the market and the price of those bonds, holding all other factors equal Once we observe the basic relationships, we introduce some of those other factors and see how they change our basic predictions about how the bond market works We can view the buyer (demander) of bonds and the seller (supplier) of bonds in two ways First, we can consider the bond 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 In the second view, the use of the funds is the good In this case, Bob Woodward, The Agenda: Inside the Clinton White House, New York: Simon & Schuster, 1994 The quotes are taken from page 130 The author gives special thanks to Steven Tomlinson of the University of Texas at Austin for recommending the joint presentation of the bond market and loanable funds 102

2 CHAPTER 6 Determining Market Interest Rates 103 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 The following chart summarizes the two views of the bond market Bond Is the Good Use of Funds Is the Good Buyer Lender who buys bond Borrower raising funds Seller Borrower issuing bond Lender supplying funds Price Bond price Interest rate The first step in determining how interest rates are determined in the bond market is to observe how the quantity varies with price In the case in which the bond is the good, the quantity of bonds will vary with the price of bonds In the case in which the loanable funds are the good, the quantity of loanable funds will vary with the interest rate Our analysis illustrates again the relationship between bond prices and interest rates that we studied in Chapter 4 The Demand Curve The first relationship we want to establish is the one between the price of bonds and the quantity of bonds demanded by lenders Let s study the demand for a one-year discount bond that will pay the owner $10,000 when the bond matures If the bond has a price of $8000 (point A in Fig 61(a)), lenders will want to purchase more of these bonds than if it has a price of $9500 (point B) This relationship between price and quantity produces the demand curve in Fig 61(a) The demand curve slopes down because the lender is willing and able to purchase more bonds when the price of the bond is low than when it is high In Fig 61(a), the demand curve illustrates the relationship between the quantity demanded of bonds (on the horizontal axis) and the price of bonds (on the vertical axis), the values of other variables being held constant Changes in the values of those other variables shift the demand curve, a point we consider later in the chapter To construct a demand curve for the bond market when we view the good exchanged as loanable funds rather than bonds, we have to find the interest rates for the discount bonds selling for $8000 and $9500 The expected return from holding the bond for one year is its yield to maturity The formula for the yield to maturity i in this case is i (Face value Discount price) / Discount price The face value is known $10,000 If the discount price is $8000, then the associated interest rate i equals (10, ) / % If the discount price is $9500, then the associated interest rate equals (10, ) / % For this interpretation, on the horizontal axis in Fig 61(b), we measure loanable funds, L, the quantity of funds changing hands between lenders and borrowers On the vertical axis, we measure the price Measuring the price of a loan as a promise requires a bit more subtlety than measuring the price of the security In this case, lenders are concerned about the interest they will earn the rental rate on their funds At a bond price of $8000, the interest rate is 25% (point A) At a price of $9500, the interest rate is 53% (point B) The demand for bonds is equivalent to the supply of

3 104 PART 2 Interest Rates loanable funds As the interest rate rises from 53% to 25%, all other things being equal, lenders are willing and able to increase the quantity of funds supplied to borrowers As Fig 61(b) shows, the supply curve for loanable funds, L s, slopes up: An increase in the interest rate makes lenders willing and able to supply more funds, all other things being equal The Supply Curve The supply curve for bonds shows us how the quantity of bonds supplied by borrowers varies with bond prices, all other things being equal Figure 62(a) plots the quantity of bonds borrowers are willing to supply as bond prices change Consider again the one-year discount bond with a face value of $10,000 Borrowers are willing and able to offer more bonds (promises to repay) when the bonds price is $9500 (point C) than when it is $8000 (point D) The supply curve for bonds, B s, slopes up To view the bond market as the demand for loanable funds, we look at the behavior of borrowers demanding loanable funds from lenders Figure 62(b) takes this approach Borrowers are willing to demand more funds when interest rates are low than when they are high At a price of $9500, the interest rate on the discount bond is 53% (point C); at a price of $8000, the interest rate is 25% (point D) As the interest rate rises from 53% to 25%, borrowers are willing and able to borrow less in the market for loanable funds Hence the demand curve for loanable funds, L d, slopes down FIGURE 61 Demand for Bonds by Lenders As shown in (a): The bond demand curve, B d, shows a negative relationship between the quantity of bonds demanded by lenders and the price of bonds, all else being equal As shown in (b): The supply curve for loanable funds, L s, shows a positive relationship between the quantity of loanable funds supplied by lenders and the interest rate, all else being equal Price of bonds, P ($) Interest rate, i (%) L s P $9500 B i 25% A P $8000 A i 53% B B d (a) Bond Market Perspective Quantity of bonds, B ($ billions) Quantity of loanable funds, L ($ billions) (b) Loanable Funds Perspective

4 CHAPTER 6 Determining Market Interest Rates 105 FIGURE 62 Supply of Bonds by Borrowers As shown in (a): The bond supply curve, B s, shows a positive relationship between the quantity of bonds supplied by borrowers and the price of bonds, all else being equal As shown in (b): The demand curve for loanable funds, L d, shows a negative relationship between the quantity of loanable funds demanded by borrowers and the interest rate, all else being equal Price of bonds, P ($) B s Interest rate, i (%) P $9500 C i 25% D P $8000 D i 53% C L d (a) Bond Market Perspective Quantity of bonds, B ($ billions) Quantity of loanable funds, L ($ billions) (b) Loanable Funds Perspective Market Equilibrium We now have enough information to determine a market interest rate in the markets for bonds and loanable funds by combining our demand and supply curves Let s work with the example of $10,000 discount bonds to see what bond price and quantity will prevail and observe what the market interest rate will be To do this, we combine the demand and supply curves in Figs 61 and 62 to produce the market diagrams in Fig 63 Which bond price and interest rate prevail? The equilibrium bond price P* is determined by the intersection of the bond demand curve, B d, and the bond supply curve, B s, which is at point E in Fig 63(a) What do we mean by equilibrium? Essentially, in equilibrium, the price of bonds and the volume of bonds tend to remain the same Neither savers nor borrowers have an incentive to change their buying or selling decisions To see why, let s consider what happens when the market is not in equilibrium We can think of markets in disequilibrium in two ways We look first at bond prices and quantities, and then at loanable funds Suppose that the price of bonds shown in Fig 63(a) is P 1 $9500, which is higher than the equilibrium price P* $9091 In this case, the quantity of bonds supplied by borrowers is greater than the quantity of bonds demanded by lenders, so there is an excess supply of bonds Lenders are buying all the bonds they want at the going price But some people who want to borrow cannot find lenders of funds Therefore they have an incentive to reduce their bond price demands so that lenders will buy their bonds As the bond price falls, two things happen First, some people who did not want to lend before do so because lenders now earn a greater return Second, some people who

5 106 PART 2 Interest Rates wanted to borrow before are no longer interested in doing so because the cost of borrowing is higher The price of bonds continues to fall until the excess supply of funds is eliminated Equilibrium is restored at a price of P* $9091, or point E, at which the quantity demanded and quantity supplied of bonds are equal Suppose, however, that the bond price in Fig 63(a) is P 2 $8000, which is less than P* In this case, the quantity of bonds that lenders demand exceeds the quantity of bonds that borrowers are willing to supply, so there is an excess demand for bonds Borrowers are selling all the bonds they want at the going price But some people who want to lend cannot find any bonds to buy at the going price Therefore they have an incentive to raise the price of the bonds they are purchasing from borrowers As the bond price rises, two things happen First, some people who did not want to borrow before do so because the cost of borrowing has declined Second, some people who wanted to lend before are no longer interested in doing so because they get a lower expected return from lending The bond price continues to rise until the excess demand for bonds is eliminated at P* $9091, at which equilibrium is reached at E The financial system makes this return to equilibrium possible We can consider the same tendency toward equilibrium in the market for loanable funds, as shown in Fig 63(b) At an interest rate of 53%, borrowers want more funds than lenders are willing to provide They must offer a higher interest rate to be able to borrow more As the interest rate rises, lenders increase their willingness to offer loanable funds, and borrowers reduce their planned spending on investment The interest rate FIGURE 63 Equilibrium in Markets for Bonds and Loanable Funds As shown in (a): At the equilibrium bond price, P*, the quantity of bonds demanded by lenders equals the quantity of bonds supplied by borrowers At any price above P*, there is an excess supply of bonds At any price below P*, there is an excess demand for bonds The behavior of bond buyers and sellers pushes the bond price to P* As shown in (b): At the equilibrium interest rate, i*, the quantity of loanable funds supplied by lenders equals the quantity of loanable funds demanded by borrowers At any interest rate below i*, there is an excess demand for loanable funds At any interest rate above i*, there is an excess supply of loanable funds The behavior of lenders and borrowers pushes the interest rate to i* Price of bonds, P ($) Excess supply of bonds B s Interest rate, i (%) Excess supply of loanable funds L s P 1 $9500 B C i 2 25% D A P * $9091 E i * 10% E P 2 $8000 D A i 1 53% B C Excess demand for bonds B d Excess demand for loanable funds L d Quantity of bonds, B ($ billions) (a) Bond Market Perspective Quantity of loanable funds, L ($ billions) (b) Loanable Funds Perspective

6 CHAPTER 6 Determining Market Interest Rates 107 continues to rise until the excess demand for loanable funds is eliminated at i* 10%, with an equilibrium at E Also recall that the demand curve for bonds represents the quantity of loanable funds that lenders are willing to supply Hence an excess demand for bonds at P 2 corresponds to an excess supply of loanable funds at interest rate i 2 25% At this interest rate, lenders are willing to offer more funds than borrowers are willing to borrow Lenders must lower the interest rate they are willing to accept to attract more borrowers As the interest rate falls, borrowers increase their willingness to obtain funds, and lenders offer less funds The interest rate continues to fall until the excess supply of loanable funds is eliminated at i* 10%, with an equilibrium at E To summarize, the behavior of buyers and sellers leads the bond market to gravitate toward the equilibrium bond price and interest rate Explaining Changes in Equilibrium Interest Rates The basic demand and supply model shows us the relationship between bond quantities and prices in the market for bonds and quantities of loanable funds and interest rates in the loanable funds market To find the equilibrium interest rate, we made some assumptions Specifically, we eliminated all other influences on the market from our analysis aside from price and quantity In the real world, other factors influence the prices of bonds that prevail in the market and change the market interest rate We describe those factors now and illustrate how they change equilibrium interest rates and bond prices When we worked with price and quantity only in our simplified model of the bond market, changes in price or quantity moved us to a different position on the same demand or supply curve For example, in Fig 61(a), when bond prices fell from $9500 to $8000, we moved along the demand curve from point B to point A and observed the resulting increase in the quantity of bonds demanded by lenders When we bring other factors into the analysis, the entire demand or supply curve shifts to the right or left The shifts are illustrated in Figs 64 and 65 (on pages 109 and 114) In the market for bonds or loanable funds, factors that increase demand shift the demand curve to the right Factors that decrease demand for bonds or for loanable funds shift the demand curve to the left In a similar fashion, factors that increase the supply of bonds or the supply of loanable funds shift the supply curve to the right Factors that decrease the supply of bonds or loanable funds shift the supply curve to the left We first describe factors that change the quantity demanded at each price and then those that change the quantity supplied at each price Shifts in Bond Demand The same criteria that savers use to select investments in the theory of portfolio allocation (Chapter 5) are those that cause the demand curve for bonds to shift These criteria include wealth, expected returns and expected inflation, risk, liquidity, and information costs As lenders, savers will consider bonds along with other investments If bonds offer advantages over alternative investments, savers will purchase bonds instead of those other investments, shifting the demand curve to the right If other investments offer greater benefits than bonds, then savers will substitute those investments for bonds, shifting the demand curve to the left We describe each factor and its impact on the demand for bonds and on interest rates

7 108 PART 2 Interest Rates Wealth Suppose savers are trying to decide how many bonds to buy The wealthier savers are, the larger the stock of savings they have available to invest in financial assets, including bonds In Fig 64(a), the bond market is initially in equilibrium at E 0, with an initial equilibrium bond price of P 0 As wealth increases in the economy, savers are willing and able to buy more bonds at any given price That is, at each bond price, the quantity of bonds demanded rises As a result, the bond demand curve B d shifts to the right, from B d 0 to B d 1 Note that the rightward shift of the bond demand curve leads to a higher equilibrium bond price, P 1 P 0 Starting again at E 0, what happens if aggregate wealth the economy s stock of savings falls? The decrease in savings shifts the bond demand curve to the left, from B d 0 to B d 2 At the new equilibrium E 2, the new bond price P 2 is lower than P 0 We examine the same effect in the loanable funds market In Fig 64(b), the loanable funds market is initially in equilibrium at E 0, with an interest rate of i 0 An increase in wealth increases lenders willingness to lend at any interest rate, and the supply curve for loanable funds shifts to the right, from L s 0 to L s 1 At the new equilibrium, E 1, the interest rate falls from i 0 to i 1 Note that the lower interest rate (Fig 64(b)) is associated with the higher bond price (Fig 64(a)) Starting again from E 0, a decrease in aggregate wealth reduces lenders ability to supply funds at any interest rate, shifting the supply curve for loanable funds to the left from L s 0 to L s 2 At the new equilibrium, E 2, the interest rate rises from i 0 to i 2 We can generalize these findings As aggregate wealth expands, the demand for bonds rises; the bond demand curve shifts to the right, raising bond prices and reducing interest rates, all else being equal As wealth falls, the demand for bonds falls; the bond demand curve shifts to the left, lowering bond prices and raising interest rates, all else being equal Expected returns and expected inflation If expected returns on bonds increase, bonds become a more attractive investment But this is not the only change in the demand for bonds that occurs when expected returns rise Bond demand is also affected by changes in the expected returns on other assets For example, if investors become more optimistic about business prospects, expected capital gains on stocks are higher, raising expected returns on equities If the expected returns on bonds do not change, the higher expected returns on stocks imply that the expected return on bonds has fallen relative to that on stocks, reducing the demand for bonds This is illustrated in Fig 64(a) by a leftward shift in the bond demand curve In the new equilibrium, the price of bonds is lower Hence the decline in the expected return on bonds relative to stocks reduces the price of bonds We can illustrate the same example from the perspective of the loanable funds market, as in Fig 64(b) A decline in the attractiveness of lending reduces lenders willingness to supply loanable funds at any interest rate The supply curve for loanable funds shifts to the left In the new equilibrium, the interest rate is higher to induce lenders to lend In general, an increase in the expected returns on other assets reduces the demand for bonds, shifting the bond demand curve to the left The price of bonds falls, and the interest rate rises A decrease in the expected returns on other assets raises the demand for bonds, shifting the bond demand curve to the right The price of bonds rises, and the interest rate falls Other financial assets are not the only alternative to bonds as investments Physical assets such as houses, cars, major appliances, or commodities also offer ways to hold

8 CHAPTER 6 Determining Market Interest Rates 109 FIGURE 64 Shifts in the Demand for Bonds As shown in (a): 1 From an initial equilibrium at E 0, as the attractiveness of holding bonds rises, the quantity of bonds demanded at any bond price also rises The bond demand curve shifts to the right from B 0 d to B 1 d In the new equilibrium, E 1, the price of bonds rises from P 0 to P 1 2 From an initial equilibrium at E 0, as the attractiveness of holding bonds falls, the quantity of bonds demanded at any bond price also falls The bond demand curve shifts to the left from B 0 d to B 2 d In the new equilibrium, E 2, the price of bonds falls from P 0 to P 2 As shown in (b): 1 From an initial equilibrium at E 0, an increase in lenders willingness to lend at any interest rate shifts the supply curve for loanable funds to the right from L s 0 to L s 1 In the new equilibrium, E 1, the interest rate falls from i 0 to i 1 2 From an initial equilibrium at E 0, a decline in lenders willingness to lend at any interest rate shifts the supply curve for loanable funds to the left from L 0 s to L 2 s In the new equilibrium, E 2, the interest rate rises from i 0 to i 2 Price of bonds, P ($) P 1 1b Bond price rises 1a Attractiveness of holding bonds rises Interest rate, i (%) B s 2a Willingness or L s 2 ability to lend falls 2b Interest rate rises E 1 i 2 E 2 L s 0 L s 1 P 0 E 0 i 0 E 0 P 2 2b Bond price falls E 2 B d 1 i 1 E 1 1a Willingness or ability to lend rises 2a Attractiveness of holding bonds falls B d 2 B d 0 1b Interest rate falls L d Quantity of bonds, B ($ billions) (a) Bond Market Perspective Quantity of loanable funds, L ($ billions) (b) Loanable Funds Market Perspective wealth These real assets tend to offer protection against expected inflation An increase in expected inflation raises expected future prices of physical assets, 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 demand for bonds to fall In Fig 64(a), the bond demand curve shifts to the left and the price of bonds falls In the loanable funds market, an increase in expected inflation makes lenders less willing to supply funds at any interest rate because they are losing purchasing power The supply curve for loanable funds shifts to the left, and the interest rate rises to compensate lenders for losses due to inflation In general, an increase in expected inflation reduces the demand for bonds, shifting the bond demand curve to the left; the price of bonds falls, and the interest rate rises A decrease in expected inflation raises the demand for bonds, shifting the bond demand curve to the right; the price of bonds rises, and the interest rate falls Risk There are two ways in which risk affects the demand for bonds First, an increase in the risk of investments in bonds reduces the demand for bonds, all other things being equal (Remember that most investors are risk-averse, so a rise in the volatility of asset returns reduces the attractiveness of holding the asset) In Fig 64(a),

9 110 PART 2 Interest Rates CONSIDER THIS Where Do Savings Come from? Increases or decreases in wealth the stock of savings affect savers demand for bonds and the supply of loanable funds Economic expansions or contractions offer a partial explanation of changes in wealth To look more deeply, we must consider the decisions that give rise to wealth in the first place: saving decisions Economists studying wealth accumulation focus on three underlying determinants: life-cycle considerations, precautionary saving, and bequest saving Life-Cycle Considerations For most of us, income and desired spending are not precisely matched at each point in our lifetimes As you might expect, students and retirees usually are not able to save much Rather, most individuals save in the middle years of their lives Accumulating and decumulating wealth helps households to smooth out spending over time Suppose you think your earnings will rise as you gain experience and fall substantially after retirement You can borrow money when you are young and broke, pay back debts and save for retirement when you are middleaged and better off financially, and live on savings and pensions in your retirement In this life-cycle story about wealth accumulation, demographics and growth are important considerations Growth in the number of younger savers relative to older dissavers or growth in incomes increases saving Precautionary Saving Another determinant of aggregate wealth of households is the stock of precautionary saving, saving in preparation for emergencies, such as sudden health care needs or the loss of a job Because no one can predict when such emergencies might arise, many people put aside some funds as a precautionary measure Some economists believe that wealth held for precautionary saving is a significant component of total wealth Bequest Saving Wealth accumulated for bequests is another component of total private wealth Not all individuals save exclusively to finance their own future spending Many who can afford to do so save to leave funds to their children and other heirs through bequests, or amounts of funds left in a will Recipients of a bequest inherit savings of the deceased and use the funds to finance their own future spending In addition, many individuals transfer wealth to their children or other relatives before death (to assist with a down payment on a home, for example) Shifts in wealth generated by changes in the determinants of saving affect prices and interest rates for securities in the economy the bond demand curve shifts to the left, and the price of bonds falls Second, an increase in the risk of another asset say stocks makes bonds relatively more attractive, increasing the demand for bonds In this case, the bond demand curve shifts to the right, and the price of bonds rises From the perspective of the loanable funds market, any change decreasing the riskiness of bonds increases lenders willingness to supply funds at any interest rate, shifting the supply curve for loanable funds to the right and reducing the interest rate All else being equal, any change that increases the riskiness of bonds reduces lenders willingness to supply funds at any interest rate, shifting the supply curve for loanable funds to the left and increasing the interest rate to compensate lenders for bearing the additional risk In general, an increase in the riskiness of bonds relative to other assets causes the demand for bonds to fall, shifting the bond demand curve to the left; the price of bonds falls, and the interest rate rises A decrease in the riskiness of bonds relative to other assets causes the demand for bonds to rise, shifting the bond demand curve to the right; the price of bonds rises, and the interest rate falls Liquidity Investors value liquidity in an asset because greater liquidity implies lower costs of selling the asset to raise funds (say, to buy a new car or take a vacation) or to invest in another asset As a consequence, if liquidity increases in the bond market, people are more willing to hold bonds at any bond price, increasing the demand for bonds The bond demand curve shifts to the right, and the price of bonds rises Changes in liquidity in other asset markets also influence the demand for bonds For example, as governments in many

10 CHAPTER 6 Determining Market Interest Rates 111 countries have deregulated brokerage commissions for trading stocks, the cost of trading has fallen, increasing stock market liquidity and, all else being equal, making holding stocks relatively more attractive than holding bonds In this case, the decline in the relative attractiveness of holding bonds shifts the bond demand curve to the left, and the price of bonds falls All else being equal, from the perspective of the loanable funds market, any change that improves liquidity in the loanable funds market increases lenders willingness to lend at any interest rate; the supply curve for loanable funds shifts to the right, and the interest rate falls Any change that reduces liquidity in the loanable funds market reduces lenders willingness to lend at any interest rate; the supply curve for loanable funds shifts to the left, and the interest rate rises to compensate lenders for the loss of liquidity In general, an increase in the liquidity of bonds relative to other assets causes the demand for bonds to rise, shifting the bond demand curve to the right; the price of bonds rises, and the interest rate falls A decrease in the liquidity of bonds relative to other assets causes the demand for bonds to fall, shifting the bond demand curve to the left; the price of bonds falls, and the interest rate rises Information costs The information costs investors must pay to evaluate assets affect their willingness to buy those assets For example, the availability of ratings of bonds released by such firms as Standard & Poor s reduces investors information costs, making bonds more attractive than assets that have higher information costs As a result, the bond demand curve shifts to the right, and the price of bonds rises In the loanable funds market, lower information costs increase lenders willingness to lend at any interest rate The supply curve for loanable funds shifts to the right, and the interest rate falls In general, a rise in the information costs for bonds relative to other assets causes the demand for bonds to fall, shifting the bond demand curve to the left; the price of bonds falls, and the interest rate rises A fall in the information costs for bonds relative to other assets causes the demand for bonds to rise, shifting the bond demand curve to the right; the price of bonds rises, and the interest rate falls Summary Table 61 summarizes reasons that the demand curve for bonds may shift Remember that the demand for bonds corresponds to the supply of loanable funds Hence, as Table 61 shows, factors that shift the demand curve for bonds to the right raising the price of bonds shift the supply curve for loanable funds to the right reducing the interest rate Factors that shift the demand curve for bonds to the left reducing the price of bonds shift the supply curve for loanable funds to the left increasing the interest rate C H E C K P O I N T You read in the morning paper that the Congress has passed a bill eliminating the tax on capital gains from holding stocks What would you expect to happen to the price and yield of bonds? The cut in the capital gains tax lowers the expected return on bonds relative to stocks; the bond demand curve shifts to the left If nothing else changes, the price of bonds falls and the yield on bonds rises Shifts in Bond Supply Shifts in the supply curve for bonds result from changes in the willingness and ability of borrowers to issue bonds at any given price or interest rate Four factors are most important in explaining the shifts in bond supply:

11 112 PART 2 Interest Rates TABLE 61 Factors That Shift the Demand Curve for Bonds Causes the equilibrium Graph of effect on All else being equal, quantity of bonds or an increase in loanable funds to Because Bonds Loanable funds wealth increase more funds are allocated to bonds P B d 0 B d 1 B s i L s 0 L s 1 L d (P rises) B (i falls) L expected returns on bonds, increase holding bonds is relatively expected interest rate more attractive P B d 0 B d 1 B s i L s 0 L s 1 L d (P rises) B (i falls) L expected inflation decrease holding bonds is relatively less attractive P B d 1 B d 0 B s i L s 1 L s 0 L d (P falls) B (i rises) L expected returns on decrease holding bonds is relatively other assets less attractive P B d 1 B d 0 B s i L s 1 L s 0 L d (P falls) B (i rises) L riskiness of bonds relative decrease holding bonds is relatively to other assets less attractive P B d 1 B d 0 B s i L s 1 L s 0 L d (P falls) B (i rises) L liquidity of bonds relative increase holding bonds is relatively to other assets more attractive P B d 0 B d 1 B s i L s 0 L s 1 L d (P rises) B (i falls) L information costs of bonds decrease holding bonds is relatively relative to other assets less attractive P B d 1 B d 0 B s i L s 1 L s 0 L d (P falls) B (i rises) L

12 CHAPTER 6 Determining Market Interest Rates expected profitability of capital, 2 business taxation, 3 expected inflation, and 4 government borrowing Expected profitability of capital Most firms borrow (issue bonds) to finance the purchase of capital assets assets such as plant and equipment that they expect to use over several years to produce goods and services In planning their needs for investment in capital assets, firms project their current and future profitability Future profitability depends on the firm s production of innovative products and services, improvements in operations as a result of using new technologies, and projections of future demand Higher expected profitability leads firms to want to borrow more to finance investment in plant and equipment that is, to supply more bonds at any price For example, when deciding whether to invest in the development of a new drug, a pharmaceutical company will consider the likely future demand for the drug Also, in a period of economic expansion, when expected profitability is high, firms are willing and able to supply more bonds at any price According to the bond market diagram in Fig 65(a), an increase in expected profitability shifts the supply curve for bonds to the right, from B s 0 to B s 1, and the price of bonds falls from P 0 to P 1 In the loanable funds diagram in Fig 65(b), an increase in expected profitability increases borrowers demand for funds to finance investment The demand curve for loanable funds shifts to the right, from L d 0 to L d 1, and the interest rate rises from i 0 to i 1 In general, an increase in expected profitability raises borrowers willingness to supply bonds; the bond supply curve shifts to the right, reducing the price of bonds and raising the interest rate A decrease in expected profitability reduces borrowers willingness to supply bonds; the bond supply curve shifts to the left, raising the price of bonds and reducing the interest rate Business taxation Corporate taxes also affect expectations about future profitability because businesses are concerned only about the profits they retain after taxes As a result, investment incentives special tax subsidies for investment increase the profitability of investment and increase firms willingness to supply bonds at any given price Using Fig 65(a), the tax breaks shift the bond supply curve to the right from B s 0 to B s 1, reducing the price of bonds from P 0 to P 1 In the loanable funds market depicted in Fig 65(b), the tax breaks increase firms demand for funds at any interest rate The demand curve shifts to the right from L d 0 to L d 1, and the interest rate rises from i 0 to i 1 Hence investment incentives, all else being equal, lead to a fall in bond prices and an increase in interest rates Conversely, higher tax burdens on the profits earned by new investment reduce firms willingness to supply bonds As Fig 65(a) shows, higher corporate profits taxes shift the bond supply curve to the left, from B s 0 to B s 2, increasing the price of bonds from P 0 to P 2 In the loanable funds market, higher corporate tax burdens reduce firms desire to borrow to finance investments In Fig 65(b), the demand curve for loanable funds shifts to the left, from L d 0 to L d 2, and the interest rate falls from i 0 to i 2 To summarize, an increase in the expected profitability of capital net of taxes increases borrowers willingness to supply bonds; the bond supply curve shifts to the right, reducing the price of bonds and raising the interest rate A decrease in the expected profitability of capital net of taxes decreases borrowers willingness to supply bonds; the bond supply curve shifts to the left, raising the price of bonds and lowering the interest rate

13 114 PART 2 Interest Rates FIGURE 65 Shifts in the Supply of Bonds As shown in (a): 1 From an initial equilibrium at E 0, an increase in the attractiveness of issuing bonds increases the quantity of bonds supplied by borrowers at any bond price The bond supply curve shifts to the right from B s 0 to B s 1 In the new equilibrium, E 1, the price of bonds falls from P 0 to P 1 2 From an initial equilibrium at E 0, a decrease in the attractiveness of issuing bonds decreases the quantity of bonds supplied by borrowers at any bond price The bond supply curve shifts to the left, from B s 0 to B s 2 In the new equilibrium, E 2, the price of bonds rises from P 0 to P 2 As shown in (b): 1 From an initial equilibrium at E 0, an increase in the willingness to borrow increases the quantity of loanable funds demanded at any interest rate The demand curve for loanable funds shifts to the right from L d 0 to L d 1 In the new equilibrium, E 1, the interest rate rises from i 0 to i 1 2 From an initial equilibrium at E 0, a decrease in the willingness to borrow decreases the quantity of funds demanded at any interest rate The demand curve for loanable funds shifts to the left, from L d 0 to L d 2 In the new equilibrium, E 2, the interest rate falls from i 0 to i 2 Price of bonds, P ($) P 2 2b Price of bonds rises 2a Attractiveness of issuing bonds falls B s 2 B s 0 B s 1 Interest rate, i (%) 1a Willingness to borrow rises E 2 E 1 i 1 1b Interest rate rises L s P 0 E 0 i 0 E 0 P 1 E 1 1a Attractiveness of issuing bonds rises i 2 2b Interest rate falls E 2 L d 1 1b Price of bonds falls 2a Willingness B d to borrow falls Ld 2 L d 0 Quantity of bonds, B ($ billions) (a) Bond Market Perspective Quantity of loanable funds, L ($ billions) (b) Loanable Funds Market Perspective Expected inflation An increase in expected inflation reduces the value of existing bonds and raises borrowers willingness to supply bonds at any bond price As Fig 65(a) shows, higher expected inflation shifts the bond supply curve to the right, from B s 0 to B s 1, reducing the price of bonds from P 0 to P 1 In the market for loanable funds, higher expected inflation increases borrowers demand for funds at any interest rate This is because, for any given nominal interest rate, an increase in expected inflation reduces the real cost of borrowing Hence, as in Fig 65(b), the demand curve for loanable funds shifts to the right, from L d 0 to L d 1, and the interest rate rises from i 0 to i 1 In general, an increase in expected inflation leads to an increase in borrowers willingness to supply bonds; the bond supply curve shifts to the right, reducing the price of bonds and increasing the interest rate A fall in expected inflation leads to a decrease in borrowers willingness to supply bonds; the bond supply curve shifts to the left, increasing the price of bonds The real cost of borrowing for firms is the expected real interest rate, which is the nominal interest rate less expected inflation

14 CHAPTER 6 Determining Market Interest Rates 115 C H E C K P O I N T Suppose you read that business optimism is leading to a large increase in borrowers demand for funds What do you think will happen to the value of your grandmother s bonds? An increase in expected profitability shifts the bond supply curve to the right If nothing else happens, the price of bonds falls, and the interest rate rises Government borrowing So far we have emphasized the influence on bond prices and interest rates of decisions by households and businesses and have ignored the role played by governments Decisions by governments can affect bond prices and interest rates in the economy Many economists believe, for example, that the series of large US government budget deficits during the 1980s and early 1990s caused the interest rate to be modestly higher than it otherwise would have been What is the government sector? It includes not only the federal government, but also state and local governments Like households and firms, the government sector can be a net lender or borrower In some periods, income from tax receipts exceeds current expenditures, so the government sector has a surplus and is a net supplier of funds At other times, the government sector runs a deficit, with expenditures greater than tax receipts, and is a net borrower of funds In either case, governments, like households, must consider their income and spending over time Cumulatively, over the long run, the government sector cannot spend more than it collects in taxes, although it can have a surplus or deficit in any given year From 1970 through 1997, the domestic government sector was a net borrower In the early 2000s, a weak economy and a surge in federal military and security spending moved the budget back into deficit in 2001, with deficits projected to remain for several years By 1998, the federal budget was in surplus, with surpluses projected for the next several years How does government net lending and borrowing affect bond prices and interest rates? Let s assume that the government s saving decisions are determined by public policies about taxes and expenditures and are not sensitive to changes in interest rates We can then add the change in government debt to the bond supply curve Suppose the federal government increases its purchases of military equipment and doesn t increase taxes; that is, the government borrows to finance the new purchases This government borrowing shifts the bond supply curve to the right If households do not change their saving in response to the increased borrowing by the government, household wealth does not change and the bond demand curve does not shift As a result, all other things being equal, the total quantity of bonds rises and the price of bonds falls This fall in the price of bonds implies that the increase in government borrowing raises the interest rate Households could increase their saving when the government borrows in order to pay the future taxes required to pay off the government s debt In this case, the bond demand curve shifts to the right at the same time that the bond supply curve shifts to the right The interest rate need not rise in response to the increase in government borrowing However, studies by economists suggest that households do not increase their current saving by the full amount of the government s dissaving Interest rates are likely to rise modestly, all else being equal, in response to an increase in government borrowing

15 116 PART 2 Interest Rates OTHER TIMES, OTHER PLACES Do Interest Rates Rise During Wartime? In wartime, governments often become temporary borrowers, as purchases of military hardware and expenditures for soldiers compensation, accommodations, and transport increase These increased expenditures are temporary, and governments generally do not increase current taxes sufficiently to pay for the war Instead, they typically borrow during wars, financing them in part by future taxes What are the effects of wars on the interest rate? In the bond supply and demand diagram, we note that a temporary increase in government purchases (holding taxes constant) should decrease bond prices If nothing else changes, then, the interest rate should rise Thus our analysis predicts that a military buildup raises the interest rate, thereby crowding out (reducing) some private borrowing Because the British fought several major and minor wars during the period from 1730 to 1913, British data are particularly useful for analyzing the effects of wars on private lending and borrowing and on the interest rate Robert Barro of Harvard University analyzed movements in real interest rates during wars, using British data for that period He found that inflation was essentially nonexistent over most of this period, making movements in nominal interest rates a good approximation of movements in the real interest rate Averaging about 35% over the period, long-term nominal interest rates in Britain rose to 55% during the American Revolution (late 1770s and early 1780s) and 6% during the Napoleonic Wars (early 1800s) Barro s analysis suggests that real interest rates rise during wars Applying Barro s findings to US wartime experiences is more difficult because, unlike the historical British experience, the US government imposed price controls and direct controls on interest rates However, during major conflicts such as the Korean War and especially World War II, private investment declined significantly relative to GDP while government purchases rose significantly relative to GDP The decline of private investment during wartime suggests that interest rates do rise during wars This result is consistent with the graph in Fig 65(b) In Fig 65(a), the rightward shift in the bond supply curve from B s 0 to B s 1 reduces the price of bonds from P 0 to P 1 From the perspective of the loanable funds market, the increase in government borrowing increases the total demand for funds at any given interest rate In Fig 65(b), the demand curve for loanable funds shifts to the right from L d 0 to L d 1, and the interest rate rises from i 0 to i 1 Robert J Barro, The Neoclassical Approach to Fiscal Policy In Robert J Barro (ed), Modern Business Cycle Theory Cambridge, Mass: Harvard University Press, 1989 Hence, if nothing else changes, an increase in government borrowing shifts the bond supply curve to the right, reducing the price of bonds and increasing the interest rate A fall in government borrowing shifts the bond supply curve to the left, increasing the price of bonds and decreasing the interest rate Summary Table 62 summarizes factors that shift the supply curve for bonds Remember that the factors that shift the supply curve for bonds also shift the demand curve for loanable funds Hence, as Table 62 shows, factors that shift the supply curve for bonds to the right (reducing the price of bonds, all else being equal) shift the demand curve for loanable funds to the right (raising the interest rate, all else being equal) Factors that shift the supply curve for bonds to the left (increasing the price of bonds, all else being equal) shift the demand curve for loanable funds to the left (reducing the interest rate, all else being equal) Using the Model to Explain Changes in Interest Rates Movements in interest rates occur because the demand for or supply of bonds or loanable funds changes In this section, we consider two examples: (1) the movement of interest rates over business cycles, or periodic fluctuations in economic activity, and (2) the movement of interest rates in response to changes in inflation In practice, many shifts in bond demand and bond supply occur simultaneously, and analysts try to

16 CHAPTER 6 Determining Market Interest Rates 117 TABLE 62 Factors That Shift the Supply Curve for Bonds Causes equilibrium Graph of effect on All else being equal, quantity of bonds or an increase in loanable funds to Because Bonds Loanable funds expected profitability increase businesses borrow to finance profitable investments P B s 0 B s 1 i L d 0 L d 1 L s B d (P falls) B (i rises) L corporate taxes on profits decrease taxes reduce the profitability of investment P B s 1 B s 0 i L d 1 L d 0 L s B d (P rises) B (i falls) L tax subsidies for increase subsidies lower the cost investment of investment, thereby increasing the profitability of investing P B s 0 B s 1 i L d 0 L d 1 L s B d (P falls) B (i rises) L expected inflation increase at any given bond price or interest rate, the real cost of borrowing falls P B s 0 B s 1 i L d 0 L d 1 L s B d (P falls) B (i rises) L government borrowing increase more bonds are offered in the economy at any given interest rate P B s 0 B s 1 i L d 0 L d 1 L s B d (P falls) B (i rises) L disentangle explanations To follow developments in the bond market, you can consult the bond page in The Wall Street Journal each day This analysis appears in the Marketplace section of The Wall Street Journal Why do interest rates fall during recessions? We can illustrate changes in interest rates over the business cycle using the bond market or loanable funds diagram At the beginning of a downturn, households and firms expect that economic activity

17 118 PART 2 Interest Rates will be lower than usual for a period of time As Fig 66(a) shows, the fall in household wealth shifts the demand for bonds to the left, from B 0 d to B 1 d At the same time, firms expect the profitability of capital to be low for a period of time, reducing their willingness to borrow to finance capital investments, so the supply of bonds shifts to the left, from B 0 s to B 1 s The equilibrium bond price rises from P 0 to P 1 In the market for loanable funds, the fall in wealth reduces lenders ability to supply funds at any interest rate; the supply curve for loanable funds shifts to the left, from L 0 s to L 1 s, as in Fig 66(b) The fall in expected profitability reduces borrowers demand for funds at any interest rate; the demand curve for loanable funds shifts to the left, from L 0 d to L 1 d The equilibrium interest rate rises from i 0 to i 1 Note that the leftward shift of the bond demand curve reduces bond prices and raises interest rates, all else being equal, whereas the leftward shift of the bond supply curve raises bond prices and lowers interest rates Evidence from US data indicates that interest rates generally rise during economic upturns and fall during economic downturns, suggesting that the bond supply shift dominates, as shown in Fig 66 Expected inflation and interest rates Interest rate forecasters pay significant attention to surveys about any signs of expected inflation Most economists credit the FIGURE 66 Interest Rate Changes in an Economic Downturn As shown in (a): 1 From an initial equilibrium at E 0, an economic downturn reduces household wealth and decreases the demand for bonds at any bond price The bond demand curve shifts left, from B d 0 to B d 1 2 The fall in expected profitability reduces lenders supply of bonds at any bond price The bond supply curve shifts left, from B s 0 to B s 1 3 In the new equilibrium, E 1, the bond price rises from P 0 to P 1 As shown in (b): 1 From an initial equilibrium at E 0, an economic downturn reduces wealth and decreases the supply of loanable funds at any interest rate The supply curve for loanable funds shifts left, from L s 0 to L s 1 2 The fall in expected profitability reduces borrowers demand for loanable funds at any interest rate The demand curve for loanable funds shifts left, from L d 0 to L d 1 3 In the new equilibrium, E 1, the interest rate falls from i 0 to i 1 Price of bonds, P ($) 1 Household wealth falls 3 Bond price rises B s 1 B s 0 Interest rate, i (%) 1 Household wealth falls L s 1 L s 0 P 1 E 1 P 0 i 0 E 0 E 0 i 1 2 Expected profitability falls 3 Interest rate falls E 1 L d 0 B d 1 B d 0 2 Expected profitability falls L d 1 Quantity of bonds, B ($ billions) (a) Bond Market Perspective Quantity of loanable funds, L ($ billions) (b) Loanable Funds Market Perspective