Behavior of Interest Rate
Lecture Notes on MONEY, BANKING, AND FINANCIAL MARKETS
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
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