INTEREST RATES

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INTEREST RATES

1.0 Measuring Interest Rates

1.1 Yield to Maturity (YTM)

• YTM is the most accurate measure of interest rates. When economists refer
to interest rate, they are really
referring to YTM
• YTM is the interest rate that equates the present value payment received
from a debt instrument with its value today. In other context, YTM is also called the
internal rate of return (IRR). We take an example of a coupon bond. Before
we proceed, what is a coupon bond?
• A coupon bond pays the owner of the bond of a fixed interest payment
(coupon payment) every year until the maturity date, when a specified
final amount (face value or par value) is repaid. A coupon bond with
$1000 face value, for example, might pay you a coupon payment of $100
per year for ten years and at the maturity date repay you the face value
amount of $1000.
• A coupon bond is identified by three pieces of information. First is the
corporation or government agency that issues the bond. Second is the
maturity date of the bond. Third is the bond’s coupon rate, the dollar
amount of the yearly coupon payment expressed as a percentage of the
face value of the bond. Treasury bonds and notes and corporate bonds
are examples of coupon bonds.
• The formula used to calculate the YTM of a coupon bond is as follows :
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 P= C C C
(1 + i)¹ (1 + i)² (1 + i)³

P = price of coupon bond

C = yearly coupon payment
F = face value f the bond (usually $1000)
n = years to maturity date

 In the above equation, C, F, n, and P are known quantities, and only the YTM (I) is not. Hence we
can solve this equation for the YTM, that is, i.

 An example: If we purchase a bond with a price of $1000 (P), 10% coupon rate (C = 0.1 x $1000),
and a maturity of 10 years (n = 10), we will get a YTM of 10%. If the price is $900, we will find that
the YTM is 11.75%. Table below shows the YTM calculated for several bond prices.

Price of Bond ($) Yield to Maturity (%) /(Interest rate)

1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81
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 Three interesting facts are illustrated by the above table :

1. When the coupon bond is priced at its face value, the YTM (I) equals the coupon rate.
2. The price of a coupon bond and the YTM are negatively related; that is, as the YTM
3. The YTM is greater than the coupon rate when the bond price is below its face value.

• Because the procedure for calculating the YTM is based on sound economic principles, this is the
measure that economists think most accurately describes the interest rate.

• From the above analysis, we can see one important fact that current bond prices and interest
rates (YTM) are negatively related. When the interest rate rises, the price of the bond falls, and vice
versa. We will also see that prices and returns for long term bonds are more volatile than those for
shorter-term bonds.

2.0 Concepts of Interest Rates and Rate of Return

2.1 Interest Rates

• Interest is a return on capital. It also refers to the price of money.
• For the borrower, interest is a payment for obtaining credit (loan) or the cost borrowing.
• for the lender, it is the amount of funds, valued in terms of money that they receive when
they extend credit. It is a reward for delaying their current consumption.
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2.2 Rates of Return (ROR/ RET)

 Rates if returns are basically returns on investments or rewards of taking risks. As well
as a person does by holding a bond or any other security over a particular period is
accurately measured by the return or, in more precise terminology, the rate of
return.
 For any security, the ROR is defined as the payments to the owner plus the change
in its value, expressed as a fraction of its purchase price. An example, a $1000-
face=value coupon bond with a coupon rate of 10% that is bought for $1000, and
held for one year, and the resold for $1200. The payments to the owner are the
yearly coupon payments of $100, and the change on its value is $1200 - $ 1000 =
$200. Adding these together and expressing them as a fraction of the purchase
price of $1000 gives us the one-year holding-period return for this bond :

 The calculation demonstrates that the return on a bond will not necessarily equal
the interest rate (YTM) on that bond.
 Rates of returns also can be defined as rewards for giving up current use of funds.
 Returns vary according to the investment vehicles being undertaken. For example,
the rates of returns on stocks, bond, saving, etc.
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3.0 Concepts of Nominal and Real Interest Rates

 3.1 Nominal Interest Rate

• Nominal interest rate is the rate of interest that is accrued at some time in the future.
• It is the rate of exchange between RM now and RM in the future.
• For example, if the nominal interest rate is 10% per annum, then a sum of RM10 borrowed this
year, is payable for
a sum of RM11 next year.
• Nominal interest rate makes no allowance for inflation, that is, it ignores the effects of inflation.

3.2 Real Interest Rate

• Real interest rate is the rate of interest at some time in future after discounting the rate of
inflation. The interest
rate is adjusted for expected changes in the price level so that it more accurately reflects the
true cost borrowing.
• The real interest rate is more accurately defined by the Fisher equation, named for Irving Fisher.
The equation
states that nominal interest rate I equals the real interest rate i plus the expected rate of
inflation TT℮. For example,
if the nominal interest rate is 10% pre annum and the inflation rate is 3%, the real interest rate is
really 7%.

• Rewriting the equation, we get :

° Real interest rate = Nominal interest rate 7 % – Expected Inflation 3 % = 4 %
° Nominal interest rate = Real interest rate + Expected Inflation
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 From the Fisher equation, we can see that a higher expected inflation rate would reduce the real interest
rate and a lower expected inflation rate would do otherwise. Hence we can safely conclude that when
the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend and vice
versa.

3.3 Determination of the Market Interest Rate

In order to understand and derive a demand curve for assets like money or bonds, we must first understand
what determines the demand for these assets. For this purpose we will look at a theory called the theory of
asset demand.

3.3.1 Determinants of Asset Demand

• An asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art, land,
houses, farm equipment, and manufacturing machinery are all assets. Facing the question of whether to
buy and hold an asset or whether to buy one asset rather than another, an individual must consider the
following factors :

1. Wealth, the total resources owned by the individual, including all assets.
• Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.
2. Expected return (the return expected over the next period) on one asset relative to alternative assets.
• Holding everything else constant, an increase in an asset’s expected return relative to that of an
alternative asset,
raises the quantity demanded of the asset.
3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets.
• A risk-averse person prefers non-risky asset while a risk preferer/risk lover prefers risky asset. Holding
everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity will fall.
4. Liquidity (the ease and speed with which an asset can be turned into cash) on one asset relative to
alternative
assets.
• 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.
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 3.3.2 Theory of Asset Demand

 All the determining factors above can be assembled into theory of asset demand, which states that,
holding all of the other factors constant :
 1. The quantity demanded of an asset is positively related to wealth.
 2. The quantity demanded of an asset is positively related to its expected return relative to alternative
assets.
 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative
assets.
 4. The quantity demanded of an asset is positively related t its liquidity relative to alternative assets.

 3.3.3 Interest Rate Determination in an Economic System : An Introduction

(Demand and Supply in the Credit Market)
 In general, the interest rate is determined through the interaction of the supply of funds (savings or also
known as supply of loanable funds) chanelled by savers (lenders/surplus units) and the demand for surplus
funds (demand for loanable funds) by borrowers (deficit units) in the credit market.
 A nation’s households and firms need not to be the only demanders of credit. In fact, local, state, and
federal government make up a very large part of the demand side of the credit market.
 There are many types of interest rates in Malaysia (not just one single rate). Examples of interest rates are
the Prime Rate, which is the prevailing maximum deposit rates and minimum lending rate (regulated by
BNM), Base Lending Rate (BLR), Preferential Rate, Inter-bank Rates, Discount Rates, and Deposits Rates
(savings and fixed).
 However, in our case of analysis, we will act as if there is only one type of security and a single interest rate
in the entire economy because interest rates on different securities tend to move together.
 Diagram 1 (page 5) shows an economic system where credit facilities exist for lenders and borrowers. S is
extended as credit. The higher the market interest rates, the more credit is extended (supplied) as shown
by the upward supply curve.
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 There are also parties (households, firms, governments, and foreigners) who do not have sufficient
capital to increase capacity for new productions or expand and diversify into new ventures. D is
extended as loan (Demand for credit). At higher market interest rates, the quantity of credit
demanded reduces because higher interest rates raise the cost of borrowing.
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•There are also parties (households, firms, governments, and foreigners) who do not have sufficient capital to increase
capacity for new productions or expand and diversify into new ventures. D is extended as loan (Demand for credit). At
higher market interest rates, the quantity of credit demanded reduces because higher interest rates raise the cost of
borrowing.
Market interest rate (%), r
S

DIAGRAM 1

Quantity of Credit (RM)

RM
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 Diagram 2 shows the shift in the demand and supply of credits caused by several factors. The
resultant effects is the change in the equillibrium market interest rate. These factors will be further
discussed in two theories of interest rate determination, that is, the classical model’s Loanable
Funds Framework and Keynes’s Liquidity Preference Framework.
S
Market interest rate (%), r
S
D D

r DIAGRAM 2

Quantity of Credit (RM)

RM

 Notes to diagram : Example of inflationary expectations and interest rate adjustments (r)

4.0 Determination of Interest Rates

• There are two predominant theories on the determination of interest rate. One is the Loanable
Funds Theory (LF) introduced by economics under the Classical school of thoughts. The second
theory is the Liquidity Preference Theory (LP) introduced by John Maynard Keyness. (Liquidity
preference is the desire to hold money instead of other assets).
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 There are many versions of the Loanable Funds Theory. Some of the analyses are conducted in
terms of stocks (amounts at a given point of time) of assets while some other analyses are in terms
of flow.

4.1 THE CLASSICAL MODEL

4.1.1. Loanable Funds Theory/Framework – Fisherian Real Interest Rate Theory

(Demand and Supply in the Savings & Investment Market)
 In this theory, real interest rate is determined by the equilibrium of demand for loanable funds
(investment) and supply of loanable funds (savings).
 The theory emphasizes on the flows of credit (loanable funds) rather than money stock.
 Loanable funds = Savings – Surplus funds ready to be lent out.
 Demand for money is only for transactionary purposes.
 Supplier of loanable funds are :
• Household = Savings
• Firms = Undistributed Profits are saved
• Federal + State Governments = Budget Surpluses
• Increase in money stock (new money)
• Decrease in demand for money
Demand
 • Household = Consumptions
 • Firms = Investments
 • Federal + State of Governments = Budget Deficits
 • Decrease in money stock
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• Increase in demand for money

 Under this theory, interest rate is ONLY determined and influenced by the level of savings (supply
of loanable funds) and investment (demand for loanable funds).
 Thus, we can conclude the followings :
• Aggregate Savings Schedule = Supply Schedule for Loanable Funds
• Real Interest Rate = Price of Loanable Funds (Credit)
• Aggregate Investment Schedule = demand Schedule for Loanable Funds
• Real Interest Rate = Price of Loanable Funds (Credit).
Aggregate
Interest rate, (S), r Investment
(Demand for Aggregate Savings
Loanable Funds = Bd) (Supply of Loanable Funds = Bs)

S>I
r1
DIAGRAM 3

r S=I
r2

S<I
Quantity of Credit
(S, I)

 In diagram 3, the interest rate, r, is determined by the interaction of the aggregate investments
(demand for loanable funds) and aggregate savings (supply of loanable funds).
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 If interest rate r1 increases above the equilibrium level r, there will be an excess supply of loanable
funds, and savings exceed desired investment. Savings will offer lower interest rate to induce
deficit units to borrow their excess loanable funds. Thus r1 will decrease back to the equilibrium
interest rate r.
 If interest rate r2, decreases below the equilibrium level r, there will be an excess demand for
loanable funds, and desired investment exceed savings. Business firms will offer higher interest
rate to induce surplus units to save their excess loanable funds. Thus r2 will increase back to the
equilibrium interest rate r.
 The Crowding-Out Effect (Government Deficit Spending)
• Under our initial analysis, we did not include the effects of goverment.
• Real Interest Rate = Price of Loanable Funds (Credit).

Circular Flow of Income

Factors ofIn A Three Sector Economy
Production
(Wages, Rent, Capital., Profit)

Income

HOUSEHOLDS FIRMS

Tax (T)
DIAGRAM 4
Govt. exp. (G) Tax (T) Govt. exp. (G)

Consumer expenditure
Goods and Services
Savings (S) Investment (I)

FINANCIAL MARKET
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 • Refer to Diagram 4, for the depiction of equilibrium in a three sector economy. Income (wage,
rent, capital, profit) received by household from the rental of factors of production is partly
consumed and partly saved. This fund is then channelled to borrowers (investment) through the
financial market.
 • Originally, savings must equate investments in order for the economy to be in equilibrium (since
savings is a leakage to the economy’s flow and investment is an injection to the economy’s flow).
Thus S = I
 • With the addition of another sector, the government, the same process applies to government
spending (which is an injection) and government receipts I.e. Tax (which is leakage). Both must
equate with each other in order for the economy to be back in equilibrium. Thus S + T = I + G
 • Government will borrow at any given interest rate when it faces budget deficit, that is, when it
spends more than what its got (when G > T).
 • The amount borrowed by the government is G – T. This borrowing will shift the demand for
credit (demand for Loanable funds). As a result, interest rate will increase from r) to r1 with the
amount of credit invreases from S = I to S = I + (G – T). Refer to diagram 5.
 • After the shift of demand from I to I + (G – T), at r0, there would be excess demand for loanable
fund thus borrowers of credit (loanable fund) would have to face a higher level of interest rate.
 • Because of the higher interest rate, savers (lenders) are willing to save more (showing an equal-
valued in consumption) whereas borrowers (businesses), will reduce their demand for credit
(private investment).
 • In conclusion, the government budget deficit will increase savings, but crowd-out an equal
amount of private consumption and private investment.
 • G – T = S, C, I
 • Thus, CROWDING-OUT EFFECTS is defined as a process where government deficit spending will
cause interest rate to rise and fall in private expenditure (consumption + investment).
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I + (G – T)
Interest rate (%)
r
I
Decrease in
Potential
r1 investment

r0

DIAGRAM 5
G-T

Quantity of
Credit (RM)
S=I S = I (G – T)

4.1.2 Loanable Funds Theory/Framework Revisited

(Demand and Supply in the Bond Market)
 Initially, under the Fisherian approach of loanable funds, we looked at the analysis of loanable
funds in terms of flows of assets, which is very tricky, especially when we encounter inflation. Now
we will look at an analysis in terms of stock of assests (asset market approach).
 An important feature of the analysis here is that supply and demand are always in terms of stocks
of assets, not in terms of flows. This approach is the dominant methodology used by economists
and we will see that there’s not much difference between the two approaches. However, from
now onwards our analysis using the loanable funds framework will focus principally on this
methodology, the asset market approach (demand and supply of bonds & loanable funds).
 Our first approach of the analysis looks at the supply and demand for bonds (an asset)
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◆ Demand for Bonds = Lenders

◆ Supply of Bonds + Borrowers
◆ Demand for Loanable Funds = Borrowers
◆ Supply of Loanable funds (which comes from savings) = Lenders

 Thus, suppliers of loanable funds are also demanders for bonds while demanders for loanable
funds are the same people supplying the bonds.
 Refer to the following diagrams :
Price Price Sb
Db

P1 P1

P0 P0

DIAGRAM 6
Quantity of Bonds
Quantity of Bonds
Q1 Q0 Q1 Q0
BOND MARKET
LENDERS BORROWERS
r% S If r% D if

r1 r1

r0 r0
Quantity of funds (If)

Q1 LOANABLE FUNDS MARKET Q1 Q0

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 Referring to Diagram 6, because a firm supplying bonds is in fact taking out a loan from a person
buying a bond, “supplying a bond” is equivalent to “demanding a loan”. Thus the supply curve
for bonds can be reinterpreted as indicating the quantity of loans demanded for each value of
interest rate. Similarly, a person buying a bond of loans demanded for each value of interest rate.
Similarly, a person buying a bond is in fact giving out a loan, “demanding a bond” is equivalent to
“supplying a loan”.

 We already know that price of a bond is always inversely with the interest rate. Thus because the
supply and demand diagrams that explain how interest are determined in the bond market most
commonly use the loanable funds terminology, this analysis is frequently referred to as the
LOANABLE FUNDS FRAMEWORK.

4.1.3 Market Equilibrium in the Loanable Funds Framework

 Referring to Diagram 7, equilibrium occurs a point C, where the demand and supply curves
intersect at a bond price of $850 (interest rate of 17.6%) and a quantity of bonds of $300 billions.
The price of P* = 850 is called the equlibrium or market clearing price. Similarly, the interest rate pf
I* = 17.6% that corresponds to this price is called the equilibrium or market-clearing interest rate.
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Price of Bonds, P ($)

(P increases )
Bs
DLF
950
A I

900
B H

C
P*=850
17.6 = I*

800
G D
DIAGRAM 7

750
F E

Bd
SLF
100 200 300 400 500
Quantity of Bonds, B
($ billions)
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 When the price is set too high, at, say, $950, the quantity of bonds supplied at point I is greater
than the quantity of bonds demanded at point A. This situation, in which the quantity of bonds
supplied exceeds the quantity of bonds demanded, is called a condition of excess supply.
 Because people want to sell more bonds than others want to buy, the price of bonds will fall and
the interest rate will increase (since both are inversely related). This process will continue until
equilibrium is reached at point C.
 If the price is set too low, at, say $750, the quantity demanded at point E is greater than the
quantity supplied at point F. This is called a condition of excess demand. People now want to
buy more bonds than others are willing to sell, and so the price of bonds will be driven up and
lowered the interest rate. This process will continue until equilibrium is reached at point C.

4.1.4. Changes in Equilibrium Interest Rate in the Loanable funds Framework

 The theory of asset demand developed previously provides a framework for deciding what
factors cause the demand curve for bond/supply of loanable funds to shift. These factors include
changes in four parameters :

1. Wealth
▨ In a business cycle expansion with growing wealth, the demand for bonds rises and the
demand curve shifts to the right.
▨ In the recession, when income and wealth are falling, the demand for bonds falls, and the
demand curve shifts to the left
▨ Savings is part of wealth. If household save more, wealth increases and the demand for
bond rises and the demand curve shifts to the right and vice versa.

2. Expected return
i. Expected return on bonds
ii. Expected inflation
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▨ Higher expected interest rates in the future lower the expected return for long-term bonds,
decrease the demand, and shift the demand curve to the left. Lower expected interest rates in
the future increases the demand for long-term bonds and shift the demand curve to the right.
▨ Changes expected return on other assets (examples: stocks, real assets) can also shift the
demand, and shift t he demand curve for bonds. If people expect that return on other assets such as
shares is higher than bond, t he demand for bond will decrease and shift the demand curve to the
left, and vice versa.
▨ An increase in the rate of inflation lowers the expected return for bonds, causing their demand to
decline and the demand curve to shift to the left. This is because of the following reasons :
▨ A change in expected inflation is likely to alter expected return on physical assets (or goods),
which affect the demand for bonds. Expected inflation, for example will increase prices of goods
and hence provides higher nominal capital gains and this will lead to a fall in the expected return on
bonds.
▨ Expected inflation will lower the real interest rate on bonds thus lowering the real return on holding
or purchasing bonds.

3. Risks of bonds
▨ An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve
to shift to
the left and vice versa.

4. Liquidity of bonds
▨ Increase liquidity of bonds results in an increased demand for bonds, and the demand curve shifts
to the right and vice versa.

5. Information costs of bonds

▨ Information costs of bonds are the costs associated in acquiring information on bonds. Examples
of the costs are cost of travelling, research, time and more importantly is the accuracy of the
information.
▨ Increased information on bonds on bonds results in an increased demand for bonds, and the
demand curve shifts to the right, and vice versa.
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Price of
Bonds, P

Bd1 to Bd2 :
-Increased wealth
-Increased liquidity
-Decreased expected interest rate
-Decreased expected inflation
-Decreased riskiness

Bd2 to Bd1 :
-The opposite of the above factors

B Quantity of
DIAGRAM 8
Bonds, Q
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 Shift in Supply of Bonds/Demand for Loanable Funds (LF)

The shift in the supply of bonds is caused by the following factors :

1. Expected profitability of capital/investment opportunities

 In a business cycle expansion, there are more expected profitable investment opportunities, the
supply of bonds increases, and the supply curve shifts to the right. Likewise in a recession, when
there are far fewer expected profitable investment opportunities, the supply of bonds falls, and
the supply curve shifts to the left.

2. Expected inflation
 The real cost of borrowing is more accurately measured by the real interest rate, which equals the
(nominal) interest rate minus the expected inflation rate.
 For a given rate, when expected inflation increases, the real cost of borrowing falls; hence the
quantity of bonds supplied increases at any given bond price and interest rate. An increase in
expected inflation causes the supply of bonds to increase and the supply curve to shift to the
right, and vice versa.

3. Government borrowing/activities
 Higher government deficits increase the government’s supply of bond and shift the supply curve
to the right. On the other hand, government surpluses decrease the supply of bonds and shift
the supply curve to the left.

4. Business taxation
 Investment incentives such as tax subsidies for investment, increase the profitability of investment
thus increase firms’ willingness to supply bonds and shift the supply curve to the right. Conversely,
higher tax burdens on the profits earned by new investment reduce firms’ willingness to supply
bond and shift the supply curve to the left.
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Price of Bonds, P

Sd1
Sd1 to Sd2 :
- Increased of expected
profitability
- Increased government deficits
Sd2 - Increased expected inflation
- Decreased business tax

Sd2 to Sd1 :
- The opposite of the above
factors

DIAGRAM 9

Quantity of Bonds, Q

- ANALY S I S -
•Cases to be analysed :
° Shift in demand for bonds/supply of LF (Supply constant)
° Shift in supply of bonds/demands for LF (Demand constant)
° Shift in demand and supply of bonds/LF
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 4.1.5 Shifts in Both Demand and Supply of Bonds

 4.1.5.1 Changes in Expected Inflation : The Fisher Effect

Price of Bonds, P ($) BS1 Interest Rate, I (%)

(P increases ) (i increases )

BS2
A
P1
i1

B
P2 i2
Bd1

Bd2
DIAGRAM 10
Quantity of Bonds, B

▨ Diagram 10 shows the effect of an increase inflation. If expected inflation rises, the expected return on bonds relative to real
assets or goods falls for any given price and interest rate. As a result, the demand for bonds falls, and the demand cure shifts
to the left from Bd1 to Bd2.
▨ The rise in expected inflation also shifts the supply curve. At any given bond price and interest rate, the real cost of borrowing
has declined, causing the quantity of bonds supplied to increase, and the supply curve shifts to the right, from Bs1 to Bs2.
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▨ As a result, the equilibrium moves from point A to point B. The equilibrium price has fallen from P1
to P2, and because the bond price is negatively related to interest rate, this means that the
interest rate has risen from i1 to i2. As a conclusion, when expected inflation rises, interest rates will
rise. This result is named the Fisher effect.
▨ Following the above analysis, if expected inflation decreases, the expected return on bonds
relative to real assets or goods increases for any given price and interest rate. As a result, the
demand for bonds increases, and the demand curve shifts to the right from Bd2 to Bd1.
▨ If there is a decrease in the expected inflation, at any given bond price and interest rate, the
real cost of borrowing has increased, causing the quantity of bonds supplied to decrease, and
the supply curve shifts to the left, from Bs2 to Bs1.
▨ As a result, the equilibrium moves from point B to point A. The equilibrium price has risen from P2
to P1, and because the bond price is negatively related to the interest rate, this means that the
interest rate has fallen from i2 to i1. As a conclusion, when expected inflation fallen, interest rates
Bs1 Interest Rate, i , (%)
will fall. (i increases )
Price of Bonds, P ($) 4.1.5.2 Business Cycle Expansion /Contraction
(P increases )
Bs2

P1 1
2
P2
Bd2

Bd1
DIAGRAM 11

Quantity of Bonds, B
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 Diagram 11 shows the effects of business cycle expansion on interest rates. In a business cycle expansion,
aggregate output (the amount of goods and services being produced in the economy) rises, so national
income increases. Hence businesses are more willing to borrow because of positive expected investment
opportunities. As a result, the supply of bonds will increase from Bs1 to Bs2.
 Expansion in the economy will also effect the demand for bonds. The theory of asset demand tells us that
in a business cycle expansion, wealth increases and the demand for bonds will rise as well. The demand
curve will shift from Bd1 to Bd2.
 As a result, the equilibrium moves from point 1 to point 2. The equilibrium price has fallen from P1, to P2,
and because the bond price is negatively related to the interest rate, this means that the interest rate has
risen from i1 to i2. As a conclusion, during business cycle expansion, interest rates will rise.
 Contraction in the economy will also affect the demand for bonds. The theory of asset demand tells us
that in a business cycle contraction, wealth decreases and the demand for bonds will fall as well. The
demand curve will shift from Bd2 Bd1.
 As a result, the equilibrium moves from point 2 to point 1. The equilibrium price has risen from P2 to P1, and
because the bond price is negatively related to the interest rate, this means that the interest rate has fallen
from i2 to i1. As a conclusion, during business cycle contraction, interest rates will fall.
 HOWEVER, the figure has been intentionally drawn so that the shift in the supply curve is greater than the
shift in the demand curve, causing the equilibrium price to fall, leading to a rise in the equilibrium interest
rate. The reason for this is that this is the outcome we actually see in empirical data. Thus depending on
whether the supply curve shifts more than the demand curve or vice versa, the new equilibrium interest rate
can either rise or fall.

4.1.6 The Liquidity Preference Framework

(Supply and Demand in the Money Market)
 The liquidity preference framework was introduced by John Maynard Keynes, in which equilibrium interest
rate is determined in terms of the supply of and demand for money. Although the two frameworks
(loanable funds and liquidity preference) look different, the liquidity preference analysis of the market for
money is closely related to the loanable funds framework of the bond market, and in most instances yield
the same predictions/results.
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 Loanable funds approach to interest rate determination focuses on the supply of and demand for
loanable funds.
 The Keynesian approach (liquidity preference) focuses on the supply of money and demand for
money. Keyness assumes that there are tow main categories of assets that people use to store
their wealth: money and bonds. Thus total wealth equals total money plus total quantity of bonds
in the economy.
 In this theory, it is assumed that individuals inherently prefer money among all financial assets.
Individuals will hold financial assets (bonds) other than money only if these nonmoney assets offer
better returns than holding money.
 According to Keyness, S = I, determines the equilibrium level of income and NOT the level of
inteest rates.
 Keynes further asserts that interest is paid to persuade people to exchange their money for less
liquid assets. Keyness believes that there are three motives behind the general preferences for
holding highly liquid money :
▶ Transaction

▶ Precaution

▶ Speculation

Yd
Transaction Motives
Demand for money is positively determined by income
Mt = f (Yd) Mt = f (r )


Y2
Interest rate does not have any influence r2
on the demand for money.

Y1
r2

Lt

Lt1 Lt2 Lt
DIAGRAM 12
 29

Precautionary Motive
 Demand for money is positively determined by income
 Interest rate does not have any influence on the demand for money

Yd Nominal Interest Rate % (r)

Mt = f (r)

Mp = f (Yd) r2
Y2

r1
Y1

Lt Lt
Lt1 Lt2
DIAGRAM 13 Lt

Speculative Motive
 Demand for money is negatively influenced by interest rate
Interest Rate (r) %

r1
r1
r1 Msp = f (r)
DIAGRAM 14
Money (M)
M2 M0 M1
 30

 Keynes asserts that people may hold balances in excess of their transactions and precautionary
needs to take advantage of changes in bond prices.
 People buy low and sell high. When bond prices are expected to fall in the future, people
postpone purchases now and hold the money in readiness for the lower future prices and vice
versa.
 The balances held for these purposes constitute the speculative demand for money (speculative
balances).
 The balance is primarily determined by the interest rate as the former is inversely related to bond
prices. If r bond prices , and if r , bond prices .

 Thus, at r2 (high interest rate), the demand for money is low because at this high interest rate the
price of bond is low. At r1, the opposite is true.
 Keynes also felt that people had some perception of a “normal” level of interest rates based on
past experience.
 If actual rates were above “normal”, their future increases would be considered less probable
hence people are inclined to hold more bonds (earning assets) and smaller money balance.
 Conversely, if interest rates are well below the “normal” level, future rate increases are expected,
and capital losses seem more likely than capital gains. In this case, larger speculative money
balances are held as investors wait for more profitable opportunities to rise.
 The low money balances at high interest rates could also be explained by the higher sacrifices
(opportunity costs) of holding money, that is the amount of interest (expected return) forgone by
not holding the alternative asset – in the case, a bond. As the interest rate on bond rises, the
opportunity cost of holding money rises, and so money is less desirable and the quantity of money
demanded must fall.
4.1.7 Determination of Interest Rate in the Liquidity Preference Theory (Money Demand
and Money Supply Analysis)
• Interest rate is determined by the intersection of the of the money supply curve and the money
demand curve. The money supply curve is vertically shaped because at this point of time, we
assume that a central bank controls the amount of money supplied.
 31

 The equilibrium where the quantity of money demanded equals the quantity of money supplied
occurs at point A.
(Interest rate) r %

r1

r2 A

Md = (liquidity preference function i.e. Mt + Mp + Msp)

r3
Money Demand
DIAGRAM 15

 Referring to Diagram 15, if interest rate is at r1, which is above r0, the quantity of money supplied is
more than the quantity of money demanded. This condition of excess supply means that people
are holding more money than they desire, so they will try to get rid of their excess money
balances by trying to buy bonds. According, they will bid up the price of bonds, and as the bond
price rises, the interest rate will fall toward the equilibrium interest rate.
 Likewise, if interest rate is at r2, there will be a shortage of supply of money because quantity of
money demanded is more than the quantity of money supplied. People will sell their only other
asset – bonds – and the price of bonds will fall. As the price of bonds fall, the interest rate will rise
toward the equilibrium rate of r0


 32

4.1.8 Changes in Equilibrium Interest Rates

Shifts in the Demand for Money

 In Keynes’s liquidity preference analysis, two factors cause the demand curve for money to shift:
income and price level.

1. Income Effect/Business Cycle Fluctuations

 In Keynes’s view, there were two reasons why income would affect the demand for money.
 First, as an economy expands and income rises, people will want to carry out more transactions
using money, with the result that they will also want to hold more money.
 The conclusion is that a higher level of income causes the demand for money to increase and the
demnd curve shift to the right.

2. Price-Level Effect/Inflation
 In Keynes’s view, people care about the amount they hold in `real terms’, that is, in terms of
goods and services that money can buy.
 When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot
be used to purchase as many real goods or services. To restore their holdings of money in real
terms to its former level, people will want to hold a greater nominal quantity of money.
 The conclusions is that a rise in the price level causes the demand for money to increase and the
demand curve shift to the right, and vice versa.

Shifts in the Supply of Money

 We will assume that the supply of money is completely controlled by the central bank. Thus an
increase in the money supply engineered by the central bank will shift the supply curve for money
to the right.
 33

 4.1.9 Changes in Equilibrium Interest Rate due to Changes in Income, the Price Level, or the
Money Supply
 a. Changes in Income
 When income is rising during a business cycle expansion (supply of money and other economic
variables held constant, ceteris paribus), interest rates will fall, and vice versa.

 Bb. Changes in Price Level

 When the price level increases, ceteris paribus, interest rates will rise, and vice versa.

 Cc. Changes in the Money Supply

 An increase in the money supply due to expansionary monetary policy by the central bank
implies that the supply curve for money shifts to the right. Thus when the money supply increases
(everything
r else reamining equal, ceteris paribus), interest rates will decline, and vice versa.
Ms

Increase in Income
DIAGRAM 16 or Price Level
r1

r0

Md1

Md0
Quantity Ms, Md
 34

r Ms0 Ms1 Ms2

r

Changes in
Money
Supply

r0
DIAGRAM 17
r1
r2

Liquidity Trap Area = Where increases in Ms

Will not influence the level of interest rate
Anymore. Monetary actions will have no effect.
 35

Changes in Money Supply Revisited

 The liquidity preference framework seems to suggest that an increase in money supply will
lower interest rates. Is this statement always true? Milton Friedman has raise the same
question.
 Friedman acknowledges that the liquidity preference is correct and calls the result- that an
increase in the money supply (everything else remaining equal) lowers interest rate – the
liquidity effect. However, he view that an increase in the money supply might not leave
“everything else equal” and will have other effects on the economy that may make interest
rate to rise (instead of fall). If these effects are substancial, it is entirely possible that when the
money supply rises, interest rates too may rise.

1. Income Effect
 Because an increasing money supply is an expansionary influence on the economy, it should
raise national income and wealth. Both the liquidity preference and the loanable funds
frameworks suggest that interest rate will then rise. Thus the income effect of an increase in the
money supply is a rise in interest rates in response to the higher level of income.

2. Price-Level Effect
 An increase in money supply can also cause the overall price level in the economy to the rise.
The liquidity preference framework predicts that this will lead to a rise in interest rates. So the
price-level effect from an increase in the money supply rise in interest rates in response to the
rise in the price level.

3. Expected-Inflation Effect
 The rising price level (the higher inflation rate) as a result from an increase in the money supply
also affects interest rates by affecting the expected inflation rate. An increase in the money
supply may lead people to expect
 36

higher price level in the future – hence the expected inflation rate will be higher. The loanable
funds framework has shown us that this increase in expected inflation will lead to a higher level of
interest rates. Therefore, the expected inflation rate will be higher. The loanable funds framework
has shown us that this increase in expected inflation will lead to a higher level of interest rates.
Therefore, the expected-inflation effect of an increase in the money supply is a rise in interest rates
in response to the rise in the expected inflation rate.

4.1.10 Further Analysis of the Determination of Interest Rate in the Liquidity Preference Theory
(Money Demand
and Money Supply Analysis) Using REAL Balances

 So far, our analysis has been concentrated to nominal analysis rather than REAL analysis, i.e. no
money balances.
 To obtain real aggregates, we have to divide the nominal aggregates with price fluctuations.
 For example, to get real money supply, we have to :
 Real interest rate = Nominal interest rate – Expected inflation
 Real interest rate = 7% - 3 % = 4 %

 Thus, equilibrium in the market for REAL money balances could be reworked as follows :
 37

r
Ms/Po

DIAGRAM 18

r0

Md

M = m/p

Mo/Po

 Our whole analysis on interest rates determination (Keynesian) thus would look different.
 A rise in the price level and an increase in the nominal money supply would have additional
effects on the level of interest rates.
 38

 Refer to the diagrams :

r
Mso/Po Ms1/Po

Increase in
Nominal Money
Supply

r0
DIAGRAM 19

r1 Md

M = M/P
Mo/Po M1/Po

Mso/Po Ms1/Po

Increase in
Nominal
Money Supply

r0
DIAGRAM 20

r1 Md

Mo/Po M1/Po
M = M/P
 39
5.0 Structure of Interest Rate

A wide pattern of interest rates in our economy is caused by the following factors :
◙ Variation in risks
◙ Marketability (differences in markets) and Liquidity
◙ Maturity
◙ Variations in tax treatment
◙ Differences in types of loans (administrative costs)

5.1 Risk Structure

◙ Given similar terms of maturity, different bonds earn different interest rates (interest rate)
because of the
differences in the following factors.

5.1.1 Maturity

♦ This is usually between the short-term or long-term bonds. People usually prefer shorter-term
maturity because it
is associated with less risks and marketability.
♦ Holding everything else constant, different maturities yield different rates (the term structure of
interest rate.)

5.1.2 Default Risk

♦ Default risk is the chance that the issuer of the bond will default, that is, unable to make interest
payments or pay
 40

off the face value when the bond matures.

♦ Default-free bonds such as the Treasury bills have no default risk as the government can always increase tax or
print money to pay off its obligations.
♦ The spread between the interest rate on bonds with default risk and default-free bonds is called the risk premium.
This premium indicates how much additional interest people must earn in order to be willing to hold a risky bond.
♦ A bond with default risk always has a positive risk premium and he higher the default risk, the larger the risk
premium will be.
♦ Investment advisory firms such Moody’s Investors Service, Standard and Poor’s Corporation and Rating Agency
Malaysia provide default risk information by rating the quality of corporate and municipal bonds in terms of the
probability of default.

Yield
(%)

Default-risk
Premium

DIAGRAM 21
Risk-free
Rate

Years to Maturity
 41

5.1.3 Administration costs/Information costs

♦ Refers to the cost of acquiring information on bonds, processing and gathering information. The activity of an
investor who devotes resources – time and money –k bond and default-free bonds” to acquire information
on an
asset reduces the expected return
on that financial asset.
♦ Also refers to the volume of loans. Larger loans may have similar administrative costs compared to smaller
loands.

5.1.4 Liquidity/Marketability

♦ A liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid
an
asset is the more desirable it is (ceteris paribus).
♦ The spread between the interest rates on two different bonds in terms of liquidity (default risk bond and
default-free
bonds) is actually the risk premiums, thus; the risk premium also reflects bonds’ liquidity. Therefore, risk
premium
is sometimes called a liquidity premium. More accurately, it should be called “risk and liquidity premium”, but
convention dictated that it be called a risk premium.
♦ Normally, the higher the liquidity of a bond (like a Treasury bills), the lower the interest rates on these bonds.

5.1.5 Taxability

♦ Securities in which interest payments are tax-exempted usually have lower yield compared to taxable
securities) the
higher the tax-exemption, the lower the interest rate.
 42

5.2 Term Structure

Another factor that influences the interest rate on a bond is its term to maturity. Bonds with
identical risk, liquidity cost, and tax characteristics may have different interest rates because the
time remaining to maturity is different.
Thus the term structure of interest rates refer to the relationship between interest rates on various
financial claims that are similar in all characteristics (default risks, information costs, liquidity, and
taxability) but different in maturities.
The term structure also refers to the relationship between the level of short-term and the long-term
interest rates.

5.2.1 Yield Curve

A yield curve potrays the relationships between yields on similar financial assets with respects to
different terms to maturity.
The steepness (slope) shoes that generally, the longer the term to maturity, the higher the yield
because lenders require a higher compensation for :
More sustained loss of liquidity
Higher lending risk
Greater uncertainty

There are four basic shapes for the yield :

Ascending (upward sloping)
Descending (downward sloping or inverted)
Flat
Humped (upward, than downward sloping)
 43

There are many theories on what determine the shapes of the four basic shapes for the yield but
we will focus on three important theories in explaining the shapes of the yield. But first, diagram 22
below depicts the four shapes of the yield curves :
Yield (%)

Ascending

Flat

Descending/Inverted
DIAGRAM 22
Humped

Years to Maturity

In Diagram 22, when yield curves slope upward, the long-term interest rates are above the short-
term interest rates, when yield curves are flat, the long-term interest rates and the short-term
interest rates are the same; and when yield curves are inverted (slope downward), the long-term
interest rates are below the short-term interest rates. Yield curves can also be humped and
sometimes other shapes than what are portrayed in Diagram 22.
 44

Besides explaining why yield curves take on different shapes at different times, a good theory of
the term structure of interest rates must explain the following three important empirical facts :
1. Interest rates on bonds of different maturities move together over time.
2. When short term interest rates are low, yield curves are more likely to have an upward slope;
when short-term interest rates are high, yield curves are more likely to sloped downward and
be inverted
3. Yield curves almost always slope upward

Three theories try to explain the yield curves: the expectations theory, the segmented market
theory, and the liquidity premium theory. The expectation theory does a good job of explaining
facts number 1 and 2, the segmented market theory can explain fact number 3 while the liquidity
premium can explain all facts because the theory is actually a combination of expectations and
segmented markets theories.

Pure Expectation l;iquidity Premium

Theory Segmented Markets
Theory
Theory
 45

5.2.1.1 Pure Expectation Theory

 Assumptions in this theory:

1) Market participants buy and sell securities on order to maximize profits
2) Long-term and short-term securities are perfect substitutes
3) There are no transaction costs in shifting between short and long-term securities
 The theory says that interest rates on a long-term bond will equal an average of short-term interest
rates that people expect to occur over the life of the long-term bond.
 Algebraically, rn = (r1 + r2 + …..rn)/n
 To simplify the theory, we can simply say that short-term interest rates will determine the interest
rates on longer-term bonds.
 To illustrate :
 Buy a 1 year bond that pays 9% interest rate
 Buy a 2 year bond pays 10% interest rate
 Strategy :
 1) Buy the 1-year bond and reinvest in the 2 nd year or
 2) Buy the 2-year bond
 If we follow the second strategy, we will earn 10% per year. In order to get similar yield using
the first strategy, we have to reinvest at 11% in order to get an average of (9% + 11%)/2 = 10%
(because bonds of different maturities are assumed to be perfect substitutes, the expected
return on both bonds must be equal. Otherwise, these two bonds will not be perfect
substitutes.)
 Thus, we can conclude that in order for us to be indifferent between the short-term or long-
term securities, the longer-term bond must pay 10% interest rates (based on assumption 2).
Hence we can safely say that short-term interest rates are a portrayal of longer-term
securities.
 46

 Using the analysis, the Pure Expectation Theory concludes the followings :
 If market participants expect short-term interest rates to increase, the yield will be of the
ascending type. Each long-term rate equals the average of current short-term rate and
the expected short-term rates over the life of long-term bond. Since longer-term bonds will
have greater number of expected short-term interest rates included in their average,
long-term interest rates will be higher than the short-term interest rates.
 Analysis using the demand/supply of bonds and interest rates, higher short-term rates
decrease demand/supply of bonds thus reducing their prices and interest rates for the
long-term bonds will increase.
 If short-term interest rates are expected to fall in the future yield curve will be the
descending type.
 If short-term interest rates are expected to remain unchanged in the future, yield curve will
be the flat type.
 If short-term interest rates are expected to increase and then fall in the future, yield curve
will be the humped type.

 The expectations theory explains fact 1 that interest rates on bonds with different maturities
move together over time. Historically, short-term interest rates have had the characteristic
that if they increase today, they will tend to be higher in the future. Hence a rise in short-term
rates will raise people’s expectations of future short-term rates. Because long-term rates are
the average of expected future short-term rates, a rise in in short-term rates will also raise long-
term rates, causing short-term and long-term rates to move together.
 This theory also explains fact 2 that yield curves tend to have an upward slope when short-
term interest rates are low and are inverted when short-term rates are high. When interest
rates are low, people expect them to rise back thus the yield curve will slope upward, and
vice versa.
 47

 5.2.1.2 Segmented Market Theory

 This theory is at the opposite extreme to the expectations theory.

 Assumptions in this theory :
 Long-term and short-term securities are imperfect substitutes (traded in different markets)
 The forces of demand supply in separate markets (long and short-term) will determine the
shape of the yield curves. Bonds of different maturities are said

 Bonds of different maturities are said to be imperfect substitutes because investors have strong
preferences for bonds of one maturity but not for another so they will be concerned with the
expected returns only for bonds of the maturity they prefer.
 For example, short-horizon investors such as commercial banks whose major liabilities consist of
short-term deposits would prefer securities with short-term maturities. On the other hand, long-
horizon investors, such as insurance companies and pension funds whose liabilities have longer
maturities, would prefer securities with long-term maturities.
 If investors prefer bonds with shorter maturities that have less interest rate risk, the theory can
explain fact 3 that yield curves typically slope upward (because demand for short-term bonds will
increase, raises the price, and reduce interest rate for short-term bonds while demand for long-
term bonds will reduce, decrease the price, and raises the interest rates).
 Fact 1 and 3 cannot explained because of the assumption of imperfect substitutes, that is, there is
no relationship or influence between short and long-term bond markets.
 An ascending yield shape implies that investors have a preference for short-term securities.
 A descending yield shape implies that investors have a preference for short-term securities.
 A flat shape implies that investors have no preference for long-term or short-term securities.
 48

Yield (%)

Ascending
ST > LT

Flat
ST = LT
DIAGRAM 23

Descending
LT > ST

Years to Maturity

5.2.1.3 Liquidity Premium Theory/Preferred Habitat Theory

 Assumptions in this Theory :

 Market participants buy and sell securities in order to maximize profits

Long-term and short-term securities are substitutes but NOT perfect substitutes. This means that the
Expected on a bond of a different maturity, but allows investors to prefer one bond maturity over another.
Investors tend to prefer shorter-term maturities.
 49

 This theory states that the interest rate on a long-term bond will equal an average of short-term
interest rates expected to occur over the life of the long-term bond (expectations theory) plus a
liquidity premium (or term premium) that responds to supply and demand conditions for that
bond.
 The theory is based on a “modified” version of the Pure Expectation Theory.
 The theory added that if yields in both short-term (s/t) bonds and long-term (l/t) bonds are the
same, lenders would prefer to hold s/t bonds i.e. lenders prefer liquidity.
 Thus, other things being equal, both securities are imperfect substitutes.
 To lure, demand for longer-term bonds, a liquidity premium (risk premium) is required.
 As a result, the long-term interest rates are the average of current short-term rate and the
expected short-term rates over the life of long-term bond + a liquidity premium (Ln).
 Algebraically, rn = (r1 + r2 + …rn)/n + Ln.
 The shape of the yield curves is basically similar to that of the Pure Expectation Theory expect in
the size of the Ln, which in times causes the shapes to change. We will see that because the
liquidity premium is always positive and grows as the term to maturity increases, the yield curve is
always above the yield curve implied by the expectations theory and has a steeper slope.
 50

Interest Rate
Liquidity Premium Theory Yield Curve

Liquidity Premium
Ln

Expectations Theory Yield Curve

0 5 10 15 20 25 30

 The theory is consistent with all three facts :

It explains fact 1 that interest rates on different-maturity bonds move together over time : A rise in short-term
interest rates indicates that the interest rates on bonds with different maturities move together over time.
Historically, short term interest rates have had the characteristics that if they increase today, they will tend to be
higher in the future. Hence a rise in short-term rates will raise people’s expectations of future short-term rates.
Because long-term rates are the average of expected future short-term rates, a rise in short-term rates will also
raise long-term rates, causing short-term and long-term rates to move together.
 51

 This theory also explains fact 2 that yield curves tend to have a steep upward slope when
short-term interest rates are low and are inverted when short-term rates are high. When
interest rates are low, people expect to rise back thus the yield curve will slope upward, and
vice versa. With the additional boost of a positive liquidity premium, long-term interest interest
rates will be substantially above current short-term rates, and the yield curve would then have
a steep upward slope. On the other hand, opposite process will happen if short-term rates
are high, despite positive liquidity premium.
 The theory explains fact 3 that yield curves typically slope upward by recognizing that the
liquidity premium rises with a bond’s maturity because of investors’ preferences for short-term
bonds. Even if short-term interest rates are expected to stay the same on average in the
future, long-term interest rates will be above short-term interest rates, and yield curves will
typically slope upward.
 For a humped or occasional appearances of inverted yield curves, it must be that at times
short-term interest rates are expected to fall so much in the future that the average of the
expected shirt-term rates is well below the current short-term rate. Even when the positive
liquidity premium is added to this average, the resulting long-term rate will still be the below
the current short-term interest rate.

 Thistotheory
Yield is the most widely accepted theory
Maturity of the term of structure of interest rates
Yield to Maturity
because it explains the major empirical facts.

Future short-term Future short-term

Interest rates Interest rates
Expected to rise Expected to stay the same

Term of Maturity Term of Maturity

 52

Yield to Maturity Yield to Maturity

Future short-term interest rates Future short-term interest rates

expected to fall moderately expected to fall sharply

Term to Maturity Term to Maturity

5.2.1.4 Uses of the Yield Curve

 Forecasting Interest Rate
 Changes in interest rates affect the price of fixed-income securities (such as bonds). For
example, the price of a bond is negatively related to interest rate. It is hence important to
DECISION forecast the level of interest rates because interest rate could influence profits or losses.
MAKING
 Further example: business people use forecasts to make investments, production, and
employment decision. Government officials use forecasts to predict future tax revenues
and expenditures and to guide policy decisions.
 53

5.2.1.4 Uses of the Yield Curve

 Forecasting Interest Rate
° Changes in interest rates affect the price of fixed-income securities (such as
bonds). For
example, the price of a bond is negatively related to interest rate. It is
hence important to
forecast the level of interest rates because interest rate could influence
profits or losses.

 Further example: business people use forecasts to make investments,

production, and
employment decision. Government officials use forecasts to predict future
DECISION
tax revenues
MAKING and expenditures and to guide policy decisions.

 Determining borrowing and Lending Maturities

° Provides borrowers and lenders with vital information on the impact of
alternative maturity choices on cost of funds or potential yield. For example,
insurance companies might prefer longer-term bonds while other
financial institutions may choose a shorter-term maturity to match their maturities of
liabilities.

 Selecting Individual Securities

° Yield curves of individual securities could provide some “insights” about
those securities. In selecting the right securities, we have to know accurately
what the securities are all about so as not to make incorrect decision.

 Pricing New Issues

° To void “overpriced” or “under priced” rates. Predicting interest rates more
accurately will avoid overpricing or under pricing of securities.
 54

TUTORIAL QUESTIONS

1. a) Using the bond market and the loanable funds market framework, identify and explain
the forces that typically result in a reduction on the level of interest rates during the
contraction phase of the business cycle.
(10 marks)
b) ‘The liquidity preference framework suggests that an increase in money supply will
necessarily lower interest rates’. Is this statement always true? Explain your answer.
(MAR 2004)
(10 marks)
2. a) Distinguish between risk structure and term structure of interest rates identifying the factors
causing the differences. (6 marks)
b) Suppose the yield cure is currently perfectly flat with yields being the same on all
government securities of all maturities. At the time when the economy is operating very
close to full employment, the government unexpectedly announces a decision to
become involve in a major foreign war. Assuming you believe in the pure
expectation theory.
i) Explain the pure expectation theory and the shapes of the yield curve. (8 marks)
ii) As a personal investor in government securities, how would you allocate your funds
between long and short-term securities? Why? (6
marks)
(MAR 2004)

3. a) Distinguish between :
i) nominal interest rates and real interest rates.
ii) risk structure and term structure of interest rates
(8 marks)
b) A yield curve shows the relationship between the market interest rates on bonds that are
identical expect in what aspects? Explain. (6
marks)
 55

c) Why does the yield curve often slope slightly upward, according to the preferred habitat
theory? Explain.
(OCT 2003) (6 marks)

4. a) What are the major elements of the demand and supply curves of the loanable funds
theory? (6 marks)

b) Suppose the economy moves into recession and that the consumers and procedures are
pessimistic about the future economic growth, how will this sentiment affects the equilibrium
real rate of interest? Use the loanable funds theory to explain your answer.
(OCT 2003) (14 marks)

5. a) Explain two determinants of the structure of the interest rates in the financial system.
(4 marks)
b) Using the Pure Expectations Theory, explain the factors which determine the various shapes
of the yield curve.
c) Why is it important to know the term structure of interest rates? (4 marks)
(APR 2003)

6. a) Using the Loanable Funds Framework, explain why interest rates tend to move in the same
directions as the
business cycle. (12 marks)

b) Using the Liquidity Preference Framework, explain why a rise in the price level causes
interest rates to rise
when nominal money supply is fixed. (8 marks)
 56

7. a) Using Loanable Funds Theory, graphically show the combined effect of an increase in the
money supply and
an increase in government demand for funds?

What would have happened if there was only an increase in government demand for
funds? In this case, how
would business investment be affected? (14 marks)

b) Using the Liquidity Preference Theory, graphically show the combined effect of a decrease
in the supply of
money and an increase in national income. What is the likely effect of this change in the
money market?
(SEPT 2002) (6 marks)

8. a) Explain the pure expectations, segmented markets and preferred habitat theories of the
yield curve.
(15 marks)
9. b) Examine how the following factors may affect the yield of security :
i) Maturity
ii) Credit Risk
iii) Marketability
iv) Callability
v) Taxability
(SEPT 2002) (5 marks)
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9. Using both the Loanable funds and Liquidity Preferences Framework, explain the effects on
the interest rates as a result of the following changes :

a) Riskiness of bonds rises. (10 marks)

b) Business cycle contraction (10 marks)

10. a) Distinguish between risk and term structures of interest rates, explaining the various factors
determining them. (10 marks)
b) “Although the Segmented Market Theory can explain why yield curves usually tend to
slope upwards, it
cannot explain why interest rates on bonds of different maturities move together over
time”. Explain and
elaborate. (10 marks)
(MAR 2002)

11. a) Using the bond market and the loanable funds market framework, explain why interest
rates are procyclical
(rising when the economy is expanding and falling when the economy is in recession).

b) Is this behaviour of the interest rates consistent with what you would expect to find with the
liquidity
preference framework? Elaborate.
(SEPT 2001)

12. a) Distinguish between risk structure and term structure of interest rates. Explain the various
factors leading to
their differences.
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b) If a yield curve appears at first to be flat and then ascending steeply, what is the market
predicting about the movement of future short-term interest rates according to the Pure
Expectations Theory? (8 marks)

c) What might the yield curve in (b) indicate about the market’s predictions of the inflation
rates in the future?
(SEPT 2001) (4 marks )

13. a) Explain three (3) factors that may cause differences in the rates of interest in your
economy.
(9 marks)

b) Define a yield curve and then illustrate the various shapes of the yield curves. Discuss two
(2) theories that
explain the shapes of the yield curves. (11
marks)
(APR 2001)

14. a) Explain the relationship between interest rates and bond prices. (6
marks)

b) How can inflation affect the equilibrium interest rate in an economy? (7

marks)

c) Explain the possible impact of recession on the market interest rate. (7

marks)
(APR 2001)

15. Explain the determination of equilibrium interest rate according to Keynesian Liquidity
 59

16. a) Using the Bond Market and the Loanable Funds Market analysis, explain how the
equilibrium rate of interest is determined in a closed economy. (8 marks)

b) Suppose the economy moves into recession and there is general pessimism about the
future econmic growth,
how will this sentiment affect the equilibrium rate of interest. (6 marks)

c) What would be the effect of an expected rise in the general price level on the equilibrium
rate of interest?
(OKT 2000) (6 marks)
17. a) Explain how the equilibrium rate of interest is determined inn the Keynesian system. (10
marks)

b) Use the theory in (a) to explain :

i) The real balance effect of a rise in the price level.
ii) The effect of an improvement in payments system technology. (10 marks)
(APR 2000)
18. a) Explain briefly two determinants of the structures of interest rates in the financial system. (4
marks)

b) Using the Pure Expectations Theory, explain why the yield curve can be ascending,
descending, or flat.
(12 marks)

c) Suggest four reasons why it is important to know the term structure of interest rate.
(OKT 1999) (4 marks)
19. a) Using both the Bond Market and Loanable Funds Market perspectives, explain how the
maket rate of interst is
determined. (10 marks)

b) How will this market rate of interest be affected by the following changes?
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i) An increase in government borrowing. (5 marks)

ii) An increase in the expected returns on other assets. (5 marks)

(APR 1999)

20. a) Suppose the economy moves into recession and that consumers and producers are
generally pessimistic about
the future economic growth, how will the sentiment affects the equilibrium real rate of
interest?(10 marks)

b) What would the effect of expected rate of inflation be on equilibrium real rate of interest?
(OKT 2000) (10 marks)