Chapter 5
The Behavior of Interest Rates
As is clear in the Preface to the textbook, I believe that money and banking is taught effectively
by emphasizing a few economic principles and then applying them over and over again to the
subject matter of this exciting field. Chapter 5 introduces one of these basic economic principles:
the theory of portfolio choice. This theory indicates that there are four primary factors that
influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The
simple idea that these four factors explain the demand for assets is, in fact, an extremely
powerful one. It is used continually throughout the study of money and banking and makes it
much easier for the student to understand how interest rates are determined, how banks manage
their assets and liabilities, why financial innovation takes place, how prices are determined in the
stock market and the foreign exchange market, and how various theories explain the demand for
money.
Chapter 5 goes on to lay out two partial equilibrium approaches to the determination of interest
rates: supply and demand in the bond market and the liquidity preference framework (supply and
demand in the money market). As is made clear in this chapter, these approaches are not
inconsistent with each other but are two different and useful ways of looking at the same thing.
(A third approach to the determination of interest rates used by some practitioners in financial
markets is the so-called loanable funds framework. An appendix to the chapter found in MyLab
Economics shows how the supply and demand analysis of the bond market developed in this
chapter relates to the loanable funds framework.)
Another important feature of this chapter is that it lays out supply and demand analysis of the
bond and money markets at a similar level to that found in principles of economics textbooks.
The ceteris paribus derivation of supply and demand curves with numerical examples are
presented, the concept of equilibrium is carefully developed, the factors that shift the supply and
demand curves are outlined, and the distinction between movements along a demand or supply
curve and shifts in the curve are clearly drawn. My feeling is that the step-by-step treatment in
this chapter is worthwhile because supply and demand analysis is such a basic tool throughout
the study of money, banking, and financial markets. I have found that even those students who
have had excellent training in their principles course find that this chapter provides a valuable
review of supply and demand analysis.
The second appendix to the chapter that can be found in MyLab Economics shows how the
analysis developed in the chapter can be applied to understanding how any asset’s price is
determined. Many students like the application to the gold market because this commodity
piques almost everybody’s interest and I teach this material in my class.