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Chapter 4
Determining Interest Rates
Brief Chapter Summary and Learning Objectives
4.1 How to Build an Investment Portfolio (pages 88–95)
Discuss the most important factors in building an investment portfolio.
The determinants of portfolio choice include wealth, an asset’s expected rate of return compared
with the expected returns on other assets, an asset’s degree of risk compared with the risk from
investing in other assets, an asset’s liquidity compared with the liquidity of other assets, and the
cost of acquiring information about the asset relative to the cost of acquiring information about
other assets.
To reduce risk, investors typically buy multiple assets, such as shares of stock issued by different
companies.
4.2 Market Interest Rates and the Demand and Supply for Bonds (pages 95–105)
Use a demand and supply model to determine market interest rates for bonds.
The demand and supply for bonds determines the prices of bonds and therefore their interest
rates.
Changes in the following factors will cause the demand curve for bonds to shift: wealth,
expected returns on bonds, risk, liquidity, and costs of information.
Changes in the following factors will cause the supply curve for bonds to shift: the expected
profitability of physical capital investment, business taxes, expected inflation, and government
borrowing.
4.3 The Bond Market Model and Changes in Interest Rates (pages 105–110)
Use the bond market model to explain changes in interest rates.
Any factor that affects the demand or supply of bonds affects bond prices and therefore interest
rates.
4.4 The Loanable Funds Model and the International Capital Market (pages 110–117)
Use the loanable funds model to analyze the international capital market.
Virtually all economies interact with the rest of the world and are open economies.
In a small open economy, the international capital market determines the domestic real interest rate,
because the domestic demand and supply for funds is too small to affect the world real interest
rate.
A large open economy is an economy that is large enough to affect the world real interest rate.
Key Terms
Closed economy An economy in which
households, firms, and governments do not
borrow or lend internationally.
Fisher effect The assertion by Irving Fisher that
the nominal interest rises or falls point-for-point
with changes in the expected inflation rate.
Diversification The division of wealth among
many different assets to reduce risk.
Expected return The rate of return expected on
an asset during a future period.
Large open economy An economy in which
changes in the demand and supply of loanable
funds are large enough to affect the world real
interest rate.
Market (or systematic) risk Risk that is
common to all assets of a certain type, such as the
increases and decreases in stocks resulting from
the business cycle.
Idiosyncratic (or unsystematic) risk Risk that
pertains to a particular asset rather than to the market
as a whole, as when the price of a particular firm’s
stock fluctuates because of the success or failure
of a new product.
Open economy An economy in which households,
firms, and governments borrow and lend
internationally.
Risk The degree of uncertainty in the return on
an asset.
Small open economy An economy in which the
quantity of loanable funds supplied or demanded
is too small to affect the world real interest rate.
Chapter Outline
Teaching Tips
The chapter begins with a brief overview of the basics of portfolio selection. The material is worth
devoting some class time to because it is the basis for the discussion of interest rate determination
in the remainder of the chapter. In addition, some of the ideas are returned to later in the text
when topics such as the behavior of financial institutions and innovations in financial markets and
institutions are discussed. Students generally find this material interesting because it provides at
least a rough guide to personal finance (see, for example, the Making the Connection, “How
Much Risk Should You Tolerate in Your Portfolio?”).
The second and third sections of the chapter present a demand and supply for bonds model of the
determination of interest rates. Students tend to find this approach intuitive and, of course, it is
consistent with the basic demand and supply model for goods and services that they will have
learned in their principles course. This approach has the drawback, though, that the graphs show
the determination of bond prices, while most discussion of the bond markets in the book focuses
on bond interest rates. Of course, the arithmetic of bond price links the price of a bond to its
yield to maturity, so that as the bond price is determined so is the interest rate. You may want to
direct students to Figure 4.1 on page 96, and the accompanying discussion, where this important
point is illustrated.
The last section of the chapter uses the loanable funds model to present a basic analysis of the
international capital market. Instructors who are pressed for time can omit this section with no
loss of continuity with the discussion in later chapters. If you cover this section, it may be worth
spending class time on Table 4.4 on page 110 of the text, which provides an overview of the
loanable funds and the demand and supply for bonds approaches to determining interest rates.
Are There Any Safe Investments?
Given the volatility of the stock market during the financial crisis of 2007-2009, many investors wanted
safer investments. At the same time, interest rates on most forms of bank deposits were at record lows,
less than the inflation rate. As a result, many investors chose to purchase Treasury or corporate bonds,
considering them to be safe investments that paid higher interest rates than most bank accounts. Many
financial advisors warn that interest rates on Treasury and corporate bonds are near record lows. If these
rates rise to their historical average, bondholders will incur significant losses.
4.1 How to Build an Investment Portfolio (pages 88–95)
Learning Objective: Discuss the most important factors in building an investment portfolio.
A. The Determinants of Portfolio Choice
The determinants of portfolio choice include wealth, an asset’s expected rate of return
compared with the expected returns on other assets, an asset’s degree of risk compared with the
risk from investing in other assets, an asset’s liquidity compared with the liquidity of other
assets, and the cost of acquiring information about the asset relative to the cost of acquiring
information about other assets.
An increase in wealth tends to increase the demand for most financial assets. Demand for some
assets, such as CDs, stocks, and bonds, are likely to increase more, while other assets, such as
checking accounts, increase less. People choose to acquire assets with higher expected rates of
return. Investors need to consider possible returns and the probability of those returns occurring
when estimating expected returns. Risk is the degree of uncertainty in the return of an asset.
Most investors are risk averse and will choose to invest in a risky asset only if they are
compensated by receiving a higher return. As a result, we tend to view a trade-off between risk
and return. The greater an asset’s liquidity, the more desirable the asset is to investors. So, an
investor will be willing to receive a lower return on a liquid asset compared to an asset that is
less liquid. Investors find assets more desirable if they do not have to spend time or money
acquiring information about them. All else equal, investors will accept a lower return on an
asset that has lower costs of acquiring information.
B. Diversification
To reduce risk, investors typically multiple assets, such as shares of stock issued by different
companies. Diversification can eliminate idiosyncratic risk, the risk associated with a particular
asset. Much of the remaining risk is market risk or systematic risk, risk that is common to all
assets of a certain type. Diversification cannot eliminate systematic risk.
Teaching Tips
In Making the Connection: Fear the Black Swan! on pages 91–92, the authors introduce the concept of a
“black swan event” that was developed by Nassim Taleb, professional investor and professor at New York
University. The basic idea of a black swan is that, occasionally, there are “unique” events that take place
(more often than people think) that have a significantly adverse effect on returns. In an article titled
“Preparing for the Next Black Swan” in the Wall Street Journal (August 21, 2010), Taleb points out that
diversification may not be sufficient in reducing risk when there are black swan events. For example, during
the financial crisis in late 2008, virtually all asset classes declined in value at the same time. Instead of
relying only on diversification, investors may instead want to use various forms of derivatives to prepare
for black swans. However, there is no free lunch, because there are costs involved in purchasing
derivatives while they may rarely be used. The authors explore this topic further in Chapter 7,
“Derivatives and Derivative Markets.”
4.2 Market Interest Rates and the Demand and Supply for Bonds (pages 95–105)
Learning Objective: Use a demand and supply model to determine market interest rates for bonds.
A. A Demand and Supply Graph of the Bond Market
The demand curve for bonds represents the relationship between the price of bonds and the
quantity of bonds demanded by investors, holding constant all other factors. As the price of bonds
increases, the interest rate on the bonds falls and bonds become less desirable to investors, so the
quantity demanded will decline, resulting in a downward-sloping demand curve. The supply curve
represents the relationship between the supply of bonds and quantity of bonds supplied by investors
who own existing bonds and by firms that are considering issuing new bonds. As the price of bonds
increases, the interest rate on the bonds falls and holders of existing bonds will be more inclined to sell
them, resulting in an upward-sloping supply curve. An excess supply of bonds leads to a lower bond
price and, therefore, a higher interest rate, whereas an excess demand for bonds leads to a higher
bond price and a lower interest rate.
B. Explaining Changes in Equilibrium Interest Rates
Along a given demand or supply curve for bonds we hold constant everything that could affect the
willingness of investors to buy bonds, or firms and investors to sell bonds, except for the price of
bonds. If any other relevant variable—such as wealth or the expected rate of inflation—changes,
then the demand (or supply) curve shifts and we have a change in demand (or supply).
C. Factors that Shift the Demand Curve for Bonds
An increase in wealth increases the demand for bonds. If the expected return on bonds rises,
relative to
expected returns on other assets, then investors will increase their demand for bonds and the demand
curve
for bonds will shift to the right. If expected inflation increases, the expected real interest rate will
decline, reducing the demand for bonds. An increase in the risk of bonds, relative to the riskiness of
other
assets, decreases the willingness of investors to buy bonds and causes the demand curve for bonds
to
shift to the left. If the liquidity of bonds increases, investors demand more bonds at any given price
and
the demand curve for bonds shifts to the right. Lower information costs for bonds causes the
demand
curve for bonds to shift to the right.
Teaching Tips
In recent years, there has been considerable concern about the sovereign debt crisis in Europe, with
particular attention paid to Greece, Portugal, Italy, and Spain. Have students discuss the response of
global investors to this crisis. Be sure to indicate how global investors fled to government bonds that are
perceived to be safe havens—such as those of Germany and the United States—resulting in a decline in
interest rates on those bonds.
D. Factors That Shift the Supply Curve for Bonds
An increase in firms’ expectations of the profitability of investments in physical capital will, holding all
other factors constant, shift the supply curve for bonds to the right as firms seek to finance new
investment. When the government raises business taxes, the profits firms earn on new investments in
physical capital decline and firms issue fewer bonds, causing the supply curve for bonds to shift to the
left. An increase in the expected inflation rate results in a decline in the real interest rate for any given
nominal interest rate, causing the supply curve for bonds to shift to the right. If the government runs a
larger budget deficit, it will need to issue more bonds, causing the supply curve for bonds to shift to the
right. If the government runs a deficit, households may save more in anticipation of higher future tax
payments, causing the demand curve for bonds to shift to the right. However, studies indicate that
households do not increase their saving by the full amount of the budget deficit, therefore, all else equal,
bond prices are likely to decline and interest rates increase.
Teaching Tips
Encourage students to spend some time reviewing the following tables:
Table 4.2, “Factors That Shift the Demand Curve for Bonds,” on page 101.
Table 4.3, “Factors That Shift the Supply Curve for Bonds,” on page 105.
4.3 The Bond Market Model and Changes in Interest Rates (pages 105–110)
Learning Objective: Use the bond market model to explain changes in interest rates.
A. Why Do Interest Rates Fall During Recessions?
During recessions, wealth declines as does the expected profitability of investments. The
decline in wealth shifts the demand curve for bonds to the left, putting downward pressure on
bond prices, while the decline in the expected profitability of investment causes the supply
curve for bonds to shift to the left, putting upward pressure on prices. Evidence from U.S. data
shows that interest rates decline during recessions, indicating that the supply curve shifts more
than the demand curve, resulting in higher bond prices.
B. How Do Changes in Expected Inflation Affect Interest Rates? The Fisher Effect
Higher expectations of inflation reduce the expected real interest rate, leading supply curve for
bonds to shift to the right and the demand curve for bonds to shift to the left. As a result, the
price of bonds declines and the interest rate on bonds increases. This result is consistent with
the Fisher effect, which states that the nominal interest rate increases one-for-one with changes
in expected inflation. Economists have found that various real-world frictions result in nominal
interest rates not always increasing or decreasing by exactly the amount of a change in expected
inflation.
4.4 The Loanable Funds Model and the International Capital Market (pages
110–117)
Learning Objective: Use the loanable funds model to analyze the international capital market.
A. The Demand and Supply for Loanable Funds
The demand curve for loanable funds, which shows the relationship between the quantity
demanded for loanable funds and the interest rate, is equal to the supply of bonds. The supply
curve for loanable funds, which relates the quantity of loanable funds supplied to the interest
rate, is equal to the demand for bonds.
B. Equilibrium in the Bond Market from the Loanable Funds Perspective
Any of the factors that cause the demand curve for bonds to shift will cause the supply curve
for loanable funds to shift. Similarly, any of the factors that cause the supply curve for bonds to
shift will cause the demand curve for loanable funds to shift. Interest rates will adjust to ensure
that the quantity demanded for loanable funds equals the quantity supplied of loanable funds.
C. The International Capital Market and the Interest Rate
Nearly all economies are open economies, where financial capital, or loanable funds, is mobile
internationally. Borrowing and lending takes place in the international capital market, which is
the capital market in which households, firms, and governments borrow and lend across national
borders. The world real interest rate is the interest rate that is determined in the international
capital market. A closed economy is an economy that has no interaction in terms of trade or
finance with other countries, which is extremely rare in today’s world.
D. Small Open Economy
In a small open economy, the quantity of loanable funds supplied or demanded is too small to
affect the world real interest rate. So, a small open economy’s domestic real interest rate equals
the world real interest rate as determined in the international capital market. If the quantity of
loanable funds supplied domestically exceeds the quantity of funds demanded domestically at
that interest rate, the country invests some of its loanable funds abroad. If the quantity of
loanable funds demanded domestically exceeds the quantity of funds supplied domestically at
that interest rate, the country finances some of its domestic borrowing needs with funds from
abroad.
E. Large Open Economy
A large open economy is an economy that is large enough to affect the world real interest rate.
The interest rate will adjust until the excess supply (demand) of loanable funds from the large open
economy equals the excess demand (supply) for loanable funds in the rest of the world, resulting in
the domestic real interest rate equaling the world real interest rate. Factors that cause the
demand and supply of funds to shift in a large open economy will affect not just the interest rate
in that economy, but the world real interest rate as well.
Teaching Tips
For years, the United States has experienced huge net capital inflows. Some people are concerned about
borrowing from abroad. Have students discuss what would happen to real interest rates in the United
States if the country restricted borrowing from overseas (to take the extreme case, what would happen if
the United States became a more closed economy).
