Four Types of Credit Market Instruments

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Assumptions:

- Two ways to hold wealth: money and bonds

- Total wealth equals total amount of money and bonds

Bs + Ms = Bd +Md

- Rearrange terms:

Bs - Bd = Md – Ms

→ If the bond market is in equilibrium, then the money market must also be in equilibrium

Demand in the Money Market: represents the amount of wealth (money) people want to hold. As nominal interest rate increases, the opportunity cost of holding money rises and decreases the quantity demanded → i rises = Md falls

Shifts in the Demand:

- Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right

- Price-level effect: A rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right

- Money Supply is controlled by the Government → an increase in Money supply shifts the supply curve for money to the right

Supply in the Money Market (vertical line): is a fixed quantity which is controlled by the central bank → changes in the nominal interest rate will not affect the quantity supplied

Equilibrium Interest Rates:

- When income is rising during a business cycle expansion interest rates will rise → Md shifts right and equilibrium interest rates rises

- When the price level increases, with the supply of money held constant, interest rate will rise → Md shifts right and equilibrium interest rates rises

- When the money supply increases, interest rates will decline. → Ms shifts right and Md remains constant and equilibrium interest rates declines (known as the liquidity effect)

Does a Higher Rate of Growth of the Money Supply lower Interest Rates?

Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates: this result is referred to as the liquidity effect. This theory largely relies on “everything else being equal”, which may not be true. The increase in the money supply could have other effects on the economy and those effects may be causing the interest rate to rise such as the effects listed below.

Which of these effects are largest and how quickly do they take effect?

Effect

Explanation

Effect on Demand

Income effect

An increase in the money supply is an expansionary approach and should raise national income and wealth

Demand curve shifts to the right

Price-Level effect

An increase in the money supply raises national income and causes prices to rise

Demand curve shifts to the right

Expected-Inflation effect

An increase in the money supply causes people to expect the prices to rise in the future

Demand curve shifts to the right

Which of these effects are largest and how quickly do they take effect?

Liquidity effect from greater money growth takes effect immediately. Income and Price-level effect take time to work because it takes time for the increasing money supply to raise the price level and income, which in turn raises the interest rates. Expected-inflation effect depends on whether people adjust their expectations slowly or quickly.

Consider a case where the increase in the money supply causes an income, price level and expected inflation effect to occur.

If the liquidity effect is larger than the other effects, the interest rate will remain low:

[pic 10]

If instead the liquidity effect is smaller than the other effects, the interest rates will rise[pic 11]

→ This indicates that if the income, price-level and expected inflation effects dominates the liquidity effect such that an increase in money supply growth leads to higher rather than lower interest rates.

Chapter 6) The Risk and Term Structure of Interest Rates

Differences in Interest Rates

Our theories assume there is only one interest rate, but in reality there are multiple interest rate. These interest rates may be different from one another at any point in time.

There are two explanations for the differences between interest rates:

- Risk structure of interest rates

- Term structure of interest rates

→ differences in i result from either risk structure or term structure

Risk Structure of Interest Rates: Bonds with the same maturity have different interest rates due to→

- Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

- Liquidity: the relative ease with which an asset can be converted into cash

- Tax considerations: interest income on municipal bonds is earned as tax-free income

Default risk:

All bonds are subject to default risk; however Canadian Government bonds are considered default-free bonds and are used to measure the riskiness of other bonds.

To compensate the saver, bonds with higher default-risk must provide a higher yield.

Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Canadian bonds

Bond Ratings:

Bond