Chapter 5 The Behavior of Interest Rates Purposes We examine how the overall level of nominal interest rates is determined and the factors that influence their behavior. We know that bond prices and interest rates are negatively related. If we can explain why bond prices change, we can also explain why interest rates fluctuate. We assume there is one type of security and a single interest rate in an economy. Loanable Funds Framework Supply and Demand in the Bond Market Determinations of asset demand An asset is a piece of property that is a store of value. Factors that affect the demand for assets Wealth Expected return Risk Liquidity Wealth Holding everything else constant, an increase in wealth raises the quantity demanded of an asset Expected returns An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset. Risk The degree of uncertainty of an asset’s return is risk. Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. Liquidity Liquidity is the degree of ease an asset can be converted into cash without incurring large costs. The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded. Theory of asset demand Holding other things constant The quantity demanded of an asset is positively related to wealth. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. The quantity demanded of an asset is negatively related to the risk of its return relative to alternative assets. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
