The Economics of Money, Banking, and

Financial Markets
Eighth Canadian Edition

Chapter 5
The Behaviour of Interest Rates

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Learning Objectives (1 of 2)
1. Identify the factors that affect the demand for assets.
2. Draw the demand and supply curves for the bond
market, and identify the equilibrium interest rate.
3. List and describe the factors that affect the
equilibrium interest rate in the bond market.
4. Describe the connection between the bond market
and the money market through the liquidity
preference framework.

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Learning Objectives (2 of 2)
5. List and describe the factors that affect the money
market and the equilibrium interest rate.
6. Identify and illustrate the effects on the interest rate
of changes in money growth over time.

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Determinants of Asset Demand
1. Wealth: the total resources owned by the individual,
including all assets
2. Expected Return: the return expected over the next
period on one asset relative to alternative assets
3. Risk: the degree of uncertainty associated with the
return on one asset relative to alternative assets
4. Liquidity: the ease and speed with which an asset
can be turned into cash relative to alternative assets

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Theory of Portfolio Choice
Holding all other factors constant, the quantity
demanded of an asset is:
1. positively related to wealth
2. positively related to its expected return relative to
alternative assets
3. negatively related to the risk of its returns relative to
alternative assets
4. positively related to its liquidity relative to alternative
assets

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Response of the Quantity of an Asset Demanded to Changes
in Wealth, Expected Returns, Risk, and Liquidity

Summary Table 5-1 Response of the Quantity of an

Asset Demanded to Changes in Wealth, Expected
Returns, Risk, and Liquidity

Variable Change in Variable Change in Quantity Demanded

Wealth ↑ ↑
Expected return relative to
↑ ↑
other assets
Risk relative to other assets ↑ ↓
Liquidity relative to other
↑ ↑
assets

Note: Only increases in the variables are shown. The effects of decreases in the variables on the quantity
demanded would be the opposite of those indicated in the rightmost column.

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Supply and Demand in the Bond Market
(1 of 2)

• Bond Demand
– By investors that are looking to buy a store of value
– Holding all else constant, a lower bond price (= higher
interest rate) increases the quantity demanded of bonds
• Bond Supply
– By corporations and the government that may sell new
bonds (as well as investors that are considering selling
their existing bonds).
– Holding all else constant, a lower bond price (= higher
interest rate), decreases the quantity supplied

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Market Equilibrium
• Market equilibrium: when the quantity demanded
equals the quantity supplied
• Bd = Bs defines the equilibrium (or market clearing)
price and interest rate
• Market forces bring the market in equilibrium
– If Bd > Bs , there would be excess demand. In this case,
the price would rise and interest rate fall
– If Bd < Bs , there would be excess supply. The price
would fall and interest rate rise

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Figure 5-1 Supply and Demand for Bonds

i = (F - P)/P

Equilibrium in the bond market occurs at point C, the intersection of the demand curve Bd and the bond supply curve Bs.
The equilibrium price is P* = $850, and the equilibrium interest rate is i* = 17.6%.

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Shifts in the Demand for Bonds (1 of 2)
Recall: demand for bonds stems from investors. When
would there be a change (= shift) in demand?
• Wealth: growing wealth shifts the demand curve for
bonds to the right
• Expected returns: higher expected future interest
rates shifts the demand curve to the left
• Expected inflation: an increase in the expected rate
of inflations shifts the demand curve to shift to the left

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Shifts in the Demand for Bonds (2 of 2)
• Risk: an increase in the riskiness of bonds causes the
demand curve to shift to the left (decrease in demand)
• Liquidity: increased liquidity of bonds shifts the
demand curve to the right (increase in demand)

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Summary Table 5–2 Factors That Shift the
Demand Curve for Bonds (1 of 2)

Change in Quantity
Change in Demanded at Each Shift in
Variable Variable Bond Price Demand Curve

Wealth ↑ ↑

Expected interest rate ↑ ↓

Expected inflation ↑ ↓

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Summary Table 5–2 Factors That Shift the
Demand Curve for Bonds (2 of 2)

Change in Quantity
Change in Demanded at Each Shift in
Variable Variable Bond Price Demand Curve

Riskiness of bonds
↑ ↓
relative to other assets

Liquidity of bonds
↑ ↑
relative to other assets

Note: Only increases in the variables are shown. The effects of decreases in the variables on demand would
be the opposite of those indicated in the remaining columns.

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Shifts in the Supply of Bonds
Recall: new bonds are sold by corporations and the
government. When would there be a change (= shift) in
supply?
• Investment opportunities: Higher expected
profitability of investment opportunities shifts the
supply curve to the right
• Expected inflation: an increase in expected inflation
shifts the supply curve to the right
• Government budget: increased budget deficit shifts
the supply curve to the right

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Summary Table 5-3 Factors That Shift the
Supply Curve of Bonds
Change in
Change in Quantity Supplied Shift in
Variable Variable at Each Bond Price Supply Curve

Profitability of investments ↑ ↑

Expected inflation ↑ ↑

Government deficit ↑ ↑

Note: Only increases in the variables are shown. The effects of decreases in the variables on the supply
would be the opposite of those indicated in the remaining columns.

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Figure 5-4: Response to a Change in Expected Inflation

When expected inflation rises, the supply curve shifts from Bs1 to Bs2, and the demand curve shifts from Bd1 to Bd2. The
equilibrium moves from point 1 to point 2, causing the equilibrium bond price to fall from P1 to P2 and the equilibrium
interest rate to rise.

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Figure 5-5: Expected Inflation and Interest Rates (Three-
Month Treasury Bills), 1953–2020

The interest rate on three-month Treasury bills and the expected inflation rate generally move together,
as the Fisher effect predicts.
Sources: Federal Reserve Bank of St. Louis FRED database: fred.stlouisfed.org/series/TB3MS;
https://fred.stlouisfed.org/series/CPIAUCSL/Expected inflation calculated using procedures outlined in
Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference
Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a
function of past interest rates, inflation, and time trends.

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Figure 5-6: Response to a Business Cycle Expansion

In a business cycle expansion, when income and wealth are rising, the demand curve shifts rightward from Bd1 to Bd 2. If
the supply curve shifts to the right more than the demand curve, as in this figure, the equilibrium bond price moves down
from P1 to P2 and the equilibrium interest rate rises.

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Figure 5-7: Business Cycles and Interest Rates (Three-
Month Treasury Bills), 1962–2020

Shaded areas indicate periods of recession. The interest rate tends to rise during business cycle expansions and fall
during recessions.
Source: Statistics Canada CANSIM series V1225312.

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The Liquidity Preference Framework
• Core assumption: there are only two ways to store
value: money and bonds
• Total wealth that is stored equals the total amount of
money and bonds that is supplied
Bs + Ms = Bd + Md
• Rearranging we get: Bs − Bd = Md − Ms
• This means that we can study equilibrium either
through the bond market or the market for money
– Standard approach in the liquidity preference
framework is to analyse matters through the lens of the
market for money
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Demand for Money in the Liquidity
Preference Framework
Demand for money:
• Core assumptions about money
– essential for transactions
– Can be used as store of value, but offers zero rate of
return
• Quantity of money demanded and bond market
interest rate have negative relationship, because
interest rate on bonds = opportunity cost of holding
money

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Supply for Money in the Liquidity
Preference Framework
Supply for money:
• Assumed to be fully controlled by the central bank
• This means supply curve is vertical in bond interest
rate (supply is perfectly inelastic)

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Figure 5-8: Equilibrium in the Market for Money

Equilibrium in the market for money occurs at point C, the intersection of the money demand curve Md and the money
supply curve Ms. The equilibrium interest rate is i* = 15%.

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Shifts in the Demand for Money
• Income Effect
– a higher level of income causes the demand for money
to increase at each given interest rate, hence demand
curve shifts to the right
• Price-Level Effect
– a rise in the price level causes the demand for money
to increase at each given interest rate, hence demand
curve shifts to the right

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Summary Table 5-4 Factors That Shift the
Demand for and Supply of Money
Change in Money Demand
Change in (Md) or Supply (Ms) at Change in
Variable Variable Each Interest Rate Interest Rate

Income ↑ Md↑ ↑

Price level ↑ Md↑ ↑

Money supply ↑ Ms↑ ↓

Note: Only increases in the variables are shown. The effects of decreases in the variables on demand and
supply would be the opposite of those indicated in the remaining columns.

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Figure 5-9: Response to a Change in Income or the Price
Level

In a business cycle expansion, when income is rising, or when the price level rises, the demand curve shifts from Md1 to
Md2. The supply curve is fixed at Ms = M. The equilibrium interest rate rises from i1 to i2.

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Figure 5-10: Response to a Change in the Money Supply

When the money supply increases, the supply curve shifts from Ms1 to Ms2 and the equilibrium interest rate falls from i1 to i2.

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Money Supply and Interest Rates
Liquidity preference framework leads to the conclusion
that an increase in the money supply will lower interest
rates: the liquidity effect
How well does the liquidity preference framework
predict the effect of expansionary monetary policy?

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Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates? (1 of 2)
Milton Friedman argued that the liquidity effect is only
part of the story. He argued that other effects kick in
when the money supply is increased:
• Income effect describes that increasing the money
supply has an expansionary influence on the
economy
– the demand curve shifts to the right

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Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates? (2 of 2)
• Price-level effect describes that an increase in the
money supply leads to a rise in the price level
– the demand curve shifts to the right
• Expected-inflation effect describes that an increase
in the money supply may lead people to expect a
higher price level in the future
– the demand curve shifts to the right

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Figure 5-11: Response over Time to an Increase in
Money Supply Growth

(a)

(b)

(c)

Each panel shows how interest rates respond over

time to an increased rate of money supply growth,
starting at time T.

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Figure 5-12: Money Growth (M2, Annual Rate) and
Interest Rates (Three-Month Treasury Bills), 1968–2020

When the rate of money supply growth began to climb in the mid-1960s, interest rates rose, indicating that the liquidity
effect was dominated by the price-level, income, and expected-inflation effects. By the early 1980s, both interest rates
and money growth reached levels unprecedented in the post–World War II period.
Source: Statistics Canada CANSIM series V122531 and V41552796.

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