Equilibrium Interest Rates

• Equilibrium Interest Rate


  The interest rate at which the quantity demanded of an asset equals the quantity supplied
• Factors affecting demand for an asset

  • Wealth
  • Expected Return
  • Risk
  • Liquidity
• Wealth


  The total resources owned by the individual, including all assets
• Expected Return


  The return expected over the next period on one asset relative to alternative assets
• Risk


  The degree of uncertainty associated with the return on one asset relative to alternative assets
• Liquidity


  The ease and speed with which an asset can be turned into cash relative to alternative assets
• Theory of Asset Demand

  • Quantity demanded of an asset is positively related to wealth, expected return, and liquidity, and negatively related to risk
• Determining the Equilibrium Interest Rate

  1. Focus on the supply and demand for bonds

  2. At lower bond prices (higher interest rates), the quantity demanded of bonds is higher

  3. At lower bond prices (higher interest rates), the quantity supplied of bonds is lower

  4. When the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price, this is the equilibrium (or market clearing) price and interest rate

  5. When there is excess demand for bonds, the price of the bond will rise and interest rate will fall

  6. When there is excess supply of bonds, the price of the bond will fall and interest rate will rise
• Factors affecting the demand for bonds change

  Equilibrium interest rates change
• Factors affecting the supply of bonds change

  Equilibrium interest rates change
• Movement along a curve


  • Quantity of bonds demanded/supplied changes due to price changes
• Shift in a curve

  • Quantity of bonds demanded/supplied changes at every price due to a change in the factors affecting the demand and/or supply of bonds
• Factors shifting the demand curve for bonds

  • Wealth (expansion with growing wealth shifts demand curve right)
  • Expected Returns (higher expected future interest rates, higher expected return on alternative assets, higher expected inflation shifts demand curve left)
  • Risk (higher riskiness of bonds shifts demand curve left, higher riskiness of alternative assets shifts demand curve right)
  • Liquidity (higher liquidity of bonds shifts demand curve right, higher liquidity of alternative assets shifts demand curve left)
• Factors shifting the supply curve for bonds

  • Expected profitability of investment opportunities (business cycle expansion shifts supply curve right)
  • Expected inflation (higher expected inflation shifts supply curve right)
  • Government budget (higher budget deficits shifts supply curve right)
• Expected inflation increases


  Interest rates increase
• Business cycle expansion


  Interest rates increase
• Shaded area = recession => interest rates decrease
• This is the ”interest rate” that equates the present value of cash flow payments received from a debt instrument with its value today.

  It is also called internal rate of return.

  Yield to Maturity
• • A coupon bond with no face value and no maturity.


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• Fisher Equation

  𝑖 = 𝑟 + 𝜋𝑒
• • makes no allowance for inflation.


  Nominal Interest Rate
• • adjusted for expected changes in the price level =>more accurate.


  Real Interest Rate
• •  Focus on the supply and demand for bonds.
  • Recall that prices and interest rates display negative relation.
  •  At lower bond prices (higher interest rates), the quantity demanded of bonds is higher (all else held constant).
  •  At lower bond prices (higher interest rates), the quantity supplied of bonds is lower (all else held constant).
  • We consider an example with a one-year discount bond.

  The determination of Interest Rates