Bond Prices & Interest Rates

BOND PRICES

If interest rates are falling then bond prices must be rising and if interest rates are rising, bond prices must be falling.

If the FED is buying bonds the NIR is falling, therefore bond prices must be rising.

If the FED is selling bonds the NIR is rising, therefore bond prices must be falling.

If the Demand for money is increasing, the NIR is increasing, and bond prices are falling.

If the Demand for money is decreasing, the NIR is decreasing, and bond prices are rising.

If Country A has a higher RIR than Country B, there will be an inflow of capital into Country A, increasing the supply of loanable funds, decreasing the RIR and therefore Bond prices will rise.

If Country A has a lower RIR than Country B, there will be an outflow of capital from Country A, decreasing the supply of loanable funds, increasing the RIR and therefore Bond prices will fall.

FRQ's

(A) 

i. The Fed will buy bonds,, the MS increases and the NIR will fall. The Federal Funds Rate is the rate of interest that banks use when making  loans to each other.. If the NIR falls the FFR will fall.

ii. What happens to the price of bonds?? If interest rates fall, Bond prices rise.

When the FED buys bonds the NIR falls and Bond prices rise.

2. 

(a) When the demand for money decreases, the NIR will decrease.

(b) When NIR falls, Bond prices rise.

2009 Macroeconomics FRQ #1

2009 Macroeconomics FRQ #1

(A) Using a CLG with both short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A.

Understand that the expected inflation rate in long-run equilibrium is the NRU (Natural Rate of Unemployment) --- A is the NRU.

(B) Calculate the real interest rate in the long run equilibrium.

Understand that: Real = Nominal (with no inflation)

                            Real = Nominal - Inflation

                            Nominal = Real + Inflation

Real (6%) = Nominal Rate (8%)  - Inflation (Expected Rate 2%)

(C) Assume now that the Fed targets an inflation (price level) rate of 3%. What open market operation should the FED undertake.

If the FED sells bonds (Contractionary policy) it will reduce the Money Supply raising the nominal interest rates. Think about it: if the inflation rate (PL) is 6% and the FED wants a lower price level (inflation rate) then it needs to decrease the (C) and (I), consumption and investment. It needs to lower the PL by decreasing the AD (aggregate demand). AD decreases and the PL / Inflation rate falls  from 6% to 3%.

Crazy tricky college board:

Looking at you college board.

 (D) Using a CLG of the money market, show how the actions of the FED in part (C), will affect the nominal interest rate.

You must have recognised that selling bonds was contractionary.

(E) How will the interest rate change you identified in part (D), affects aggregate demand in the short-run.

If the FED sells bonds (Contractionary policy) it will reduce the Money Supply raising the nominal interest rates. Think about it: if the inflation rate (PL) is 6% and the FED wants a lower price level (inflation rate) then it needs to decrease the (C) and (I), consumption and investment. It needs to lower the PL by decreasing the AD (aggregate demand). AD decreases and the PL / Inflation rate falls  from 6% to 3%.

(F) Assume that the FED's actions are successful. What will happen to the following  as the economy approaches a new long-run equilibrium.

(i) Short-run phillips curve 

(ii) The NRU (natural rate of unemployment)

The NRU (natural rate of unemployment) remains unchanged at 5%

Nominal vs Real / Money Supply vs Loanable Funds

Fiscal Policy = Loanable Funds = Real Interest Rate  

Monetary Policy = Money Market = Nominal Interest Rate

1) Loanable Funds

Loanable funds graph has the real interest on the vertical axis and the quantity of loanable funds on the horizontal. The supply curves show the amount of loanable funds that people have saved and are willing to loan. The demand curve is the businesses and individuals that would like to borrow. 

Equilibrium shows the real interest rate for the country.

The real rate of interest is crucial in making investment decisions. Business firms want to know the true cost of borrowing for investment. If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation, and the inflation rate is negative, then the real interest rate will be larger. (Pride)

Loanable Funds = Money in banks that can be loaned out to individuals and firms

The real rate of interest is: (an eye on the price level/inflation)

• the opportunity cost of borrowing/loaning money 
• expressed in constant dollars (inflation adjusted value) 
• value or purchasing power of money used
• percentage increase in purchasing power the borrower pays (adjusted for inflation)

The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. 

The supply of loanable funds is based on the savings of the private sectors.

2) Money Market

The money market graph has nominal interest rate on the vertical axis and the horizontal axis is labeled the quantity of money. The supply of money is perfect inelastic as the money supply is controlled by the FED. The demand for money curve is downward sloping. Price level changes will effect the demand for money as will interest rate changes.

The nominal rate of interest is:

• the opportunity cost of holding money
• expressed in current dollars  (non-inflation adjusted value)
• price paid for the use on money (no eye on inflation)
• percentage increase in money the borrower pays (not adjusted for inflation)

The supply of money is based on the actions of the FED.

Why Nominal rates ?? -  the money supply deals with inflation and nominal value, not real value, while an increase in the money supply is the cause of Price level changes (inflation). 

In the long run an increase in the Money Supply will cause the demand for money to increase and the Nominal Interest Rate to rise.

Thanks, Michelle,,