Summary ECS3701_Notes_ Monetary Economics ,STUDY NOTES 2022 (All Units)

ECS3701_Notes_ Monetary Economics.STUDY NOTES 2022 (All Units). CHAPTER 1: WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS Why study financial markets? Securities - a claim on the issuer’s future income or assets that is sold by a borrower to a lender. Securities may also be referred to as financial instruments. Financial instruments may be divided into two main categories: money market instruments (e.g. Negotiable Certificate of Deposit (NCDs), Commercial Papers; Retirement Annuity (RAs) and Bankers Acceptance (Bas)) and capital market instruments (e.g. bonds and shares). Bonds - a specific type of security, namely a debt security that promises to make payments periodically for a specified period of time. Interest rate - cost of borrowing or the price paid for the rental of funds. “The” interest rate is made up of a number of different interest rates that exist in an economy. E.g. mortgage, car loan etc Bond Market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and it is where interest rates are determined. Stock Market is the market in which claims on the earnings of corporations (shares of stocks) are traded. In SA we refer to the trading of shares rather than stocks. Stock (share) - equity: a financial instruments representing part ownership of a corporate entity. Sometimes referred to as common stock as compared to the more specialized type of share, e.g. preference shares. Issuing shares is a way in which a company can raise funds. Importance of stock /stock market: the price (value) of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. The higher the price of a firm’s shares the more money can be raised to buy, e.g. machinery and equipment to increase production. Also, as per the study guide: the stock market creates a facility for financial investors to invest their surplus funds and for firms to facilitate real investment. Why study financial institutions and banking? Structure of the Financial System: The financial system is complex, comprising many different types of private sector financial institutions (banks, insurance companies, mutual funds, finance companies, investment banks) all of which are heavily regulated by Government. 4 ECS 3701 Lecture Notes Nicolas Souvaris Financial Intermediaries - institutions that borrow funds from people (surplus units) who have saved and in turn make loans to others (deficit units). Financial Innovation - shows how creative thinking on the part of financial institutions can lead to higher profits. To keep in touch with what is happening within the financial systems of the world it is necessary to study the changes that innovation has brought about. One example is the way in which dramatic improvements in information technology have brought about new means of delivering financial services electronically (e-finance). Why study money and monetary policy? Definition of money: money is defined as anything that is generally accepted in payment for goods and services (in terms of its function as a medium of exchange). In this course, the term money generally refers to the money supply. Importance of Money: money is linked to changes in economic variables and is important to the health of the economy. Money plays an important role in generating business cycles: empirical data indicates that, in the USA, the rate of growth in money supply has declined before every recession; however, not every decline in money growth is followed by a recession. Inflation is believed to be caused by continuing increases in money supply. Money plays an important role in interest rate fluctuations. Aggregate Output: gross domestic product (GDP) = the market (total) value of all final goods and services produced in a country during the course of a year. Aggregate Income: total income received for the use of factors of production (land, labour and capital) used to produce all the goods and services in the economy during the course of the year. Business Cycles: the upward and downward movement of aggregate output produced in the economy. Aggregate price level: the average price of goods and services in an economy. Three commonly used measures are the GDP deflator (nominal GDP divided by real GDP), the consumer price index (CPI) and the personal consumption expenditure deflator (PCE). Inflation: a continual increase in the aggregate price level in an economy. The price level and money supply generally rise together. 5 ECS 3701 Lecture Notes Nicolas Souvaris Monetary Policy: the management of money and interest rates by the central monetary authorities. Because money can affect many economic variables in the economy, politicians and policymakers care about the conduct of monetary policy. Real versus Nominal GDP: nominal GDP indicates that current prices are used to measure GDP. Real GDP is nominal GDP adjusted to remove inflation and using constant prices from an identified base year. Don’t forget to study Appendix 1 at the end of the chapter! Typical Examination questions 1.1 Explain briefly and in general terms what is the meaning of a security and how it facilitates direct lending and borrowing. (5) 1.2 Explain briefly what is a common stock, what purpose it serves and how it affects business investment decisions. (4) 1.3 List two ways in which the quantity of money may affect the economy. (2) 1.4 Explain the difference between nominal and real GDP and the purpose for which each should be used. (4) 1.5 List and define three commonly used measures of the aggregate price level. (6) True or false review questions Money: 1. Monetary economics primarily teaches students how to make money quickly and effortlessly. 2. A decrease in the interest rate normally increases the money stock in the economy. 3. Because money is complex, it is difficult to demonstrate the real advantages of money within the economy. 4. The use of money introduces sources of instability in the economy. 5. When interest rates rise, then all households are worse off. Securities: 6. A security is a financial instrument. In simple terms it is a "piece of paper" which is sold by the issuer to investors in exchange for funds. The security promises to repay these funds (plus interest) over the term of the security by means of a number of (one or more) future payments to the holder of the security. 7. A security is issued mostly by firms and government that wish to borrow money. 8. The issuer of a security promises to make future payments to the holder (purchaser) of the security. 9. The purchaser of a security provides cash to the issuer of a security. 10. The purchaser of a security is the lender (provider of funds). 11. The issuer of a security is the borrower of funds. 12. The holder (purchaser) of the security receives future payment/s from the issuer of the security. 6 ECS 3701 Lecture Notes Nicolas Souvaris 13. Securities can be traded on the financial market. When holder A of a security sells the security in the financial market at the going market price to B then B pays cash to A and B receives the remaining payments of the security. 7 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 2: AN OVERVIEW OF THE FINANCIAL SYSTEM Function of financial markets. Functions and advantages of financial markets in general: they allow funds to flow from people who lack productive investment opportunities but have surplus funds, to people who have such opportunities but do not have the funds to make it happen Direct financing: borrowers borrow funds directly from lenders in the financial markets by selling them securities. Remember that both borrowers and/or lenders can be households, businesses, government and foreigners. Indirect financing: this refers to the activities of financial intermediaries such as commercial banks in facilitating and reconciling the different requirements of borrowers and lenders via the process of financial asset transformation. [Example: banks accept deposits from savers and lend that money out to borrowers.] Financial markets are critical for producing an efficient allocation of capital. Structure of financial markets How does a debt instrument work? A debt instrument is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payment) until a specified date when the final payment is made (maturity date). Maturity of a debt instrument: number of years (term) until the instruments expires or becomes paid up. It is short-term if it is less than a year and longterm if it is ten years or longer with the intermediate-term being between one and ten years. In South Africa however, any financial instrument with a lifespan that is longer than a year is referred to as long-term and is traded in the capital market. An equity instrument: is a claim to share in the income and net assets of a business. It is more commonly known as a stock or share. An advantage of such an instrument is that the holder owns part of the business. You essentially own a part of the business and are therefore awarded the right to vote on important issues to the firm as well as elect the directors. You will also benefit from an increase in the firms profitability or asset value. A disadvantage is that the holder is a residual claimant. This means that the business must pay its debt holders before it pays its equity holders. Such an instrument has no maturity date. The structure of the different financial markets relates to the type of functions and the type of financial instruments that are found in each of them.  Debt and Equity markets: Debt market is that market in which debt instruments are traded, while an equity market is a market in which equity instruments are traded, e.g. stock exchange. 8 ECS 3701 Lecture Notes Nicolas Souvaris  Primary and Secondary markets: Primary market is the market in which financial instruments are issued, while the secondary market is the market in which financial instruments are traded. o An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities and guarantees a price for a corporations securities and then sells them to the public.  Exchanges and OTC Markets: Secondary markets can be organised in two ways:  Exchanges: a place specifically designed for the meeting of buyers and sellers of securities.  Over-the-counter-markets: dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to buy (e.g. US bond market).  Money and Capital Markets: the money market is the market in which short-term financial instruments are traded, such as TBs, NCDs, CPs etc. The capital market is where longer-term financial instruments are traded e.g. stocks and long-term bonds. Financial (Money) Market Instruments Treasury Bills (TBs): short-term (1, 3, 6 month) debt instrument issued by government. It is a primary security. It represents a claim on the government payable at some future date. TBs are fully secured and guaranteed by the government in SA. Negotiable Certificate of Deposit (NCD): a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. Negotiable NCDs are sold in the secondary market. Commercial Paper: a short-term debt instrument issued by large banks and well-known corporations. In SA it is described as a short- or medium-term security (securities) issued by corporations and other non-banking institutions to acquire working capital. Banker’s Acceptances (BAs): a bank draft (a promise of payment) issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it. The firm issuing the instrument is required to deposit the required funds into its account with the bank to cover the draft. 9 ECS 3701 Lecture Notes Nicolas Souvaris Repurchase agreements (Repos or RAs): short-term loans (normally less than two weeks) for which TBs serve as collateral. Most notable lenders in this case is large corporations. Capital Market Instruments Debt and equity instruments have maturities of greater than one year (medium and long term) and are traded in the capital market. Prices of these instruments fluctuate more than those of money market instruments. Generally considered to be riskier investments. Stocks: equity claims on the net income and assets of a corporation. Mortgages: loans to households and/or firms to purchase housing, land or other real structures where the structure or land serves as collateral for the loans. The mortgage market is the largest debt market in the USA. Corporate Bonds: long-term bonds issued by corporations with very strong credit ratings. Typical corporate bond will grant the holder an interest payment twice a year and pays off the face value when the bond matures (on maturity date). Convertible Bonds: Work in the same way as corporate bonds with the added benefit of the holder being able to convert the bond into a specified number of shares of stock at any time up to the maturity date. Government Securities: long-term debt instruments issued by the Treasury to finance deficits of the central government. They are the most widely traded bonds in the USA (and in SA). They are also the most liquid of the securities traded in the secondary market. Local government bonds are also referred to as municipal bonds. The market for these bonds in South Africa is very limited. In the US the income on these bonds is exempt from federal taxes and state taxes. 10 ECS 3701 Lecture Notes Nicolas Souvaris Function of financial intermediaries The main function of financial intermediaries is moving funds between borrowers and lenders in the economy. This process is referred to as financial intermediation and is the primary way in which funds are moved from lenders to borrowers. In order to understand the importance of this form of “financing” it is necessary to consider the role of each of the following:  transaction costs  risk sharing  information costs in financial markets Transaction costs: financial intermediaries can substantially reduce transaction costs because they can take advantage of economies of scale. They can also provide customers with liquidity services which make it easier to conduct transactions e.g. cheque accounts and providing interest on these accounts. Risk sharing: financial intermediaries can help reduce the exposure of investors to risk through the process of risk sharing. They create and sell assets with risk characteristics that people are comfortable with and then the financial intermediaries can use these funds to buy and sell other assets that are more risky. Costs are kept low by the fact that intermediaries are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This may also be referred to as asset transformation. Risk sharing is also made possible by diversification which entails investing in a collection (portfolio) of assets, the returns of which do not all move in the same direction. 11 ECS 3701 Lecture Notes Nicolas Souvaris Information costs: this specifically refers to the problems that occur when the parties involved in a transaction do not have the same level of information. This is referred to as asymmetric information. Lack of information creates problems before the transaction is entered into (adverse selection) and after the transaction (moral hazard). [Ref page 41 TB] Adverse Selection: ………………………………………………………………………………………… ………………………………………………………………………………………………… ……………….………………………………………………………………………………… Moral Hazard: ………………………………………………………………………………………………… ………………………………………………………………………………………………… ………………………………………………………………………………………………… Promoting efficiency in financial markets: financial intermediaries provide liquidity services, promote risk sharing and solve information problems, thereby also make it possible for small savers and borrowers to benefit from the existence of the financial markets. Types of Financial Intermediaries Depository institutions: commonly referred to as banks. These are institutions that accept deposits from individuals and other non-bank institutions and make loans. They include: commercial banks; savings and loan associations (S & L); mutual savings banks, credit unions. Contractual Savings institutions: financial intermediaries that acquire funds at periodic intervals on a contractual basis. Liquidity of assets is not as important to these institutions and they tend to invest their funds primarily in long-term securities. They include life insurance companies; short-term insurers (fire and casualty); pension and retirement funds. Investment intermediaries: which include finance companies (raise funds by selling commercial paper and stocks and bonds); mutual funds (sell shares to individuals and use the funds to invest in a diversified portfolio of stocks and bonds); money market mutual funds (characteristics of a mutual fund but also function as a depository institution). Investment banks: are not banks or financial intermediaries in the ordinary sense. They do not lend out their deposits. Investment banks help corporations issue securities by advising them on what securities are best to issue ie: stocks or bonds and then helps sell (underwrite) the securities by buying them from the corporations and reselling them in the market. 12 ECS 3701 Lecture Notes Nicolas Souvaris Regulation of the financial system The purpose of regulation is to: (a) Increase information to investors, and (b) To ensure the soundness of financial intermediaries and their different forms, etc. Typical Examination questions 2.1 Briefly explain the function of financial markets, the meaning of direct and indirect financing and the meaning of a financial intermediary. (5) 2.2 Explain the differences between debt and equity markets, primary and secondary markets, exchanges and OTC markets, and money and capital markets. (10) 2.3 List and explain the operation of any three money market instruments. (3x5=15) 2.4 List and explain the operation of any three capital market instruments. (3x5=15) 2.5 Explain the functions performed by financial intermediaries and how and why these promote economic efficiency in financial markets. (8) 2.6 Explain the broad purpose and methods used in government regulation of the financial system. (6) True or false review questions 1. If a firm borrows money from a bank to finance its debt, it is an example of indirect finance. 2. If government sells treasury bills to investors to finance a deficit, then it engages in direct financing. 3. If a firm issues a bond that repays the debt over a five-year period, then the firm engages in indirect financing. 4. The term to maturity of a bond remains constant over the term of the bond. 5. The existence of a well-functioning secondary market for a financial instrument ensures the liquidity of the financial instrument. 6. Over-the counter-markets which simultaneously operate in different locations, buy and sell at fixed prices and ignore market conditions. 7. US government securities are long-term debt instruments and are the most liquid securities traded on the capital market. 8. Primary bond markets are more important than secondary bond markets. New lending and borrowing occur in primary markets only, and it is these new issues which are ultimately important. The secondary market does not create new lending and borrowing. 9. In a world of no information and transaction costs, financial intermediaries would not exist. 10. If there were no asymmetry in the information that a borrower and a lender had, there could still be a moral hazard problem. 13 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 3: WHAT IS MONEY? Meaning of money Define money: economists define money as anything that is generally accepted in payment for goods and services or in repayment of debts. Money does not mean the same as wealth or income. In a modern economy money consists of two major components: currency plus deposits (M = C + D) Wealth: consists of money but also includes assets such as stocks, bonds, houses, cars etc. Income: is the flow of earnings per unit of time. Money on the other hand is a stock at a given point in time. Functions of money Medium of Exchange: money serves as a medium of exchange allowing it to be used as payment for goods and services. As such it promotes economic efficiency by reducing the time taken for transactions to take place. Money needs the following characteristics: 1. Standardised: simple for everyone to ascertain its value. 2. Widely accepted 3. Divisible: so that it is easy to make change. 4. Easy to carry 5. Not deteriorate quickly Unit of Account: used to measure value of goods and services in an economy and helps to reduce transaction costs by reducing the number of prices that need to be considered. Store of Value: serves as a store of purchasing power from the time the income is earned to the time it is spent. Wealth = total collection of pieces of property that serve to store value. Income = Flow of earnings per unit of time. Evolution in the payment system The history of money is closely linked to the payment system. Several hundred years ago, the payments system in all but the most primitive societies was based primarily on precious metals. The introduction of paper currency lowered the cost of transporting money. The next major advance was the introduction of cheques which lowered the transaction costs still further. Currently the move is towards an electronic payments system in which paper is eliminated and transactions are handled by computers. This will likely lower 14 ECS 3701 Lecture Notes Nicolas Souvaris transaction costs still further. The following table explains the different terms in relation to the different types of payment systems and the related concepts: Description Advantages Disadvantages Commodity Money: money made up of precious metals or other valuable commodities. An early medium of exchange that was universally acceptable. This form of money is very heavy and is hard to transport from place to place. Fiat Money: paper currency decreed by government as legal tender. Largely dependent upon trust of the value of currency. Much lighter than precious metals or even coins. Easily stolen. Can be expensive to transport in large quantities. Cheques: an instruction from you to your bank to transfer money from your account to someone else’s account. Allow transactions to take place without carrying around large sums of money. Improved the efficiency of the payment system. Loss from theft is greatly reduced. Takes time to get cheques from place to place. The administration required to support the use of cheques is expensive. Electronic payments: transmit payments via the internet. “Money” moves directly from one persons account to that of another. It is quick and efficient. It is a cheap means of payment. Problems of making errors in transmission do exist and are really difficult to reverse. While security is good, there is a risk of “hackers” being able to intervene in transactions. E-Money: substitute for cash and exists only in electronic form. The debit card is a form of e-money. Efficient and convenient. Expensive to set up. Electronic means of payment raise security and privacy concerns. Leaves an electronic trail which contains personal data. NOTE: The following must be studied from the study guide: C7 Measuring money in South Africa The customary measures of money are M1, M2 and M3. Learn the descriptions from Study Guide, pages 11 - 14. Note the following:  The measures are all based on the relationship: M = C + D and differ according to which types of deposits are included. Make sure you can describe each of them (M1, M2, M3) 15 ECS 3701 Lecture Notes Nicolas Souvaris C8 What causes money stock to increase?  Net increases in bank loans to the private sector contribute, by far, most of the increase in M3.  M = C + D where D is deposits held by the private nonbank sector with the banks. Only when D changes does the stock of money change. These deposits change because of the following:  Banks’ loans to firms and individuals  Transactions in financial assets between banking sector, central bank and private sector.  Government transactions with the private nonbank sector (pays for services or changes taxes).  Foreign exchange transactions (exports +, imports -) C9 Can government print money? Make sure you are able to answer this question, specifically compare the two ways in which the money supply is increased. Refer to pages 15 - 17 in the study guide. 1. Printing banknotes and coins. a. Only SARB has right to print money b. SARB sells new money to the banks and pays proceeds to government. c. Banks use extra money to replace old worn notes or will issue it to private sector when they need it in exchange for deposits. Money stock has still not increased yet. d. Only when government decides to spend extra money (build a school) then deposits of private building contractor and therefore money stock will increase. This process can be dangerous if government is corrupt and misuses printing press to create excessive money. 2. Forcing central bank to buy excessive issues of government securities (government borrows excessively from central bank) – monetization of government debt. a. Government issues new government securities to central bank b. Government spends newly acquired deposits, say by paying its employees, then private sector deposits (money stock) increases. c. Consequences: MV = PY. If V and Y are constant then increases in M cause increases in P d. Hyperinflation occurs when this process is repeated many times over. E.g. Zimbabwe Typical Examination questions 3.1 Provide a formal definition of money. Then explain how the money stock is measured in principle. (5) 3.2 Briefly distinguish between money and income, and money and wealth. (4) 3.3 List and explain the three primary functions of money. (3x2=6) 16 ECS 3701 Lecture Notes Nicolas Souvaris 3.4 Explain the meaning of the following terms as well as the advantages/ disadvantages of each in facilitating payments: (5x3=15): Commodity money, fiat money, cheques, electronic payment, e-money. 3.5 Define the following measures of aggregate money stock in South Africa: M1A, M1, M2, M3.(4x2=8) 3.6 Explain the meaning and implications of the government "printing" money. (10) True or false review questions 1. In principle, economists are not exactly sure how to measure money. 2. The use of a credit card to purchase goods does not affect the money stock. 3. The following transactions typically increase the money stock: a. trade credit b. payment of taxes c. government expenditure d. exports e. imports 4. An increase in the interest rate will cause increases in M1A and M3. 17 ECS 3701 Lecture Notes Nicolas Souvaris Part two: Financial markets (Textbook: chapters 4, 5 and 6) CHAPTER 4: UNDERSTANDING INTEREST RATES Measuring interest rates (Calculations not included) Interest rates are most accurately measured by the concept yield to maturity. Present value (PV): is a concept used to compare one kind of debt instrument with another. This is based on the notion that a rand (dollar) paid to you one year from now is less valuable to you then, than a rand (dollar) paid to you today. Also referred to as present discounted value. Four types of credit market instruments: these are categorized according to the timing of their cash flow payments: 1. Simple loan: the lender provides the borrower with an amount of funds (the principal) which must be repaid to the lender at the maturity date, along with an additional payment for interest. Money market instruments are of this type. For simple loans the simple interest rate equals the yield to maturity. Formula (SG pg 21): PV = CF/ (1 + i)n (where CF is cash flow at end of period n) 2. Fixed payment loan: lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period, consisting of part of the principal and interest for a set number of years. Example: mortgage payments on houses or cars. In this case the fixed yearly payment and the number of years until maturity are known quantities, only the yield to maturity is not. For example, if you borrowed $1000, a fixed-payment loan might require you to pay $126 every year for 25 years. (Refer textbook page 111). Formula: (SG pg 21): LV = + ( ) + ( ) + …..+ ( ) (where i is interest rate per period, LV is the Loan Value, FP is Fixed Payments) 3. Coupon bond: pays the owner of the bond a fixed interest payment (coupon) every year until the maturity date, when a specified final amount (face value/ par value) is repaid. Four pieces of information are required for a coupon bond: 1) the issuing party (government or corporation), 2) The maturity date of the bond 3) The coupon rate 4) Face value of the bond. 18 ECS 3701 Lecture Notes Nicolas Souvaris Three important facts relating to coupon bonds: (i) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. (ii) The price of a coupon bond and the yield to maturity are negatively related (when the yield to maturity rises, the price of the bond falls). (iii) The yield to maturity is greater than the coupon rate when the bond price is below its face value. A higher interest rate implies that the future coupon payments and final payment are worth less when discounted back to the present, therefore, the price of the bond must be lower. Formula (textbook pg 115): P = ( ) + ( ) + ( ) + …. + ( ) + ( ) Where C is coupon rate and F is final payment or face value of bond C, F and n are fixed when the bond is issued. The current market price then determines i: the yield to maturity of the coupon bond. 4. Discount bond (also called zero-coupon bond): bought at a price below its face value (at a discount) and the face value is repaid at the maturity date. A discount bond does not make interest payments, it only pays the face value. The yield to maturity is negatively related to the current bond price. Formula (textbook pg 118): i = (where i is yield to maturity) The borrower receives P (current price of discount bond at beginning of period), he repays F (face value of bond) at end of period (one year’s time). The concept of PV is used to compare these different types of instruments based on their respective yield to maturity. Yield to Maturity: of the several common ways to calculate interest rates, the most important is the yield to maturity, the interest rate that equates the PV of cash flow payments received from a debt instrument with its value today. This is the most accurate measure of interest rates. Distinction between interest rates and returns The rate of return can be defined as payments to the owner plus the change in its value, expressed as a fraction of its purchase price. The return on a bond is not necessarily equal to the yield to maturity on a bond. The return on a security shows how well you have done by holding this 19 ECS 3701 Lecture Notes Nicolas Souvaris security over a stated period of time and it can differ substantially from the interest rate measured by the yield to maturity. Because of fluctuating interest rates, the capital gains and losses on longterm bonds can be large. [When an investor sells a financial instrument before its maturity date, the sale will be subject to market rates. These market rates mean that the instrument might be sold at a profit or a loss depending on whether prices have increased or decreased.] E.g. With a $1000 face value coupon bond with a coupon rate of 10% that is bought for $1000, held for one year and then sold for $1200. The payments to owner are the yearly coupon payments of $100 and the change in 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: $ $ $ = $ $ = 0.30 = 30% This demonstrates that the return on a bond will not necessarily equal the yield to maturity on that bond. Therefore, the return on a bond held from time t to time t + 1 is: R = Where C = coupon payment Pt = price of bond at time t The following factors are important: (i) Rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds where the terms to maturity are longer than the holding period. (ii) The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change. (iii) The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the increase in interest rate. [P↓→i↑] (iv) Even if a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise. Maturity and volatility of bond returns: prices and returns for longer-term bonds are more volatile than those for shorter-term bonds. The riskiness of an asset’s return that results from interest rate changes is so important that it has been given a special name: interest-rate risk. Bonds that have a maturity that is longer than the holding period are subject to interest-rate risk. The only time this risk is eliminated is when the holding period and the maturity period are the same. This is because the price at the 20 ECS 3701 Lecture Notes Nicolas Souvaris end of the holding period is already fixed at the face value. The change in interest rates can then have no effect on the price at the end of the holding period for these bonds, and the return will therefore be equal to the yield to maturity known at the time the bond is purchased. Distinction between nominal and real interest rates Nominal interest rates: makes no allowance for inflation. Real interest rates: interest rate is adjusted by subtracting expected changes in price level. When real interest rates are low there are greater incentives to borrow and fewer incentives to lend. Indexed Bonds: a bond whose interest and principal payments are adjusted for changes in price levels and whose interest rate thus provides a direct measure of real interest rates. These bonds are useful to policy makers, because by subtracting their interest rate from a nominal interest rate on a non-indexed bond, they generate more insight into expected inflation, a valuable piece of information. Typical Examination questions 4.1 Explain the meaning of the following four types of credit market instruments (4x3=12) Simple loan, fixed payment loan, coupon bond, discount bond. 4.2 Explain the meaning of the following concepts in the context of a coupon bond: coupon rate, yield to maturity and the return on a bond. (7) 4.3 Distinguish between the nominal and the real interest rate. Which one is more important and why?(5) True or false review questions 1. The yield to maturity (i) of each of the four types of credit market instruments and its price (P, PV or LV, whatever applies) are inversely related. 2. Investors cannot ever be worse off when investing in bonds. 3. A negative real interest rate on coupon bonds implies that the interest earned on the bond does not fully compensate for the loss of purchasing power of money. Thus the investor is worse off. 21 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 5: THE BEHAVIOUR OF INTEREST RATES The supply and demand analysis for bonds provides one theory of how interest rates are determined. It predicts that interest rates will change when there is a change in demand because of changes in income (or wealth), expected returns, risk or liquidity, or when there is a change in supply. An alternative theory of how interest rates are determined is provided by the liquidity preference framework, which analyses the supply of and demand for money. It shows that interest rates will change when there is a change in the demand for money because of changes in income or the price level or when there is a change in the supply of money. Determinants of demand for assets and direction of effect of changes Factors that determine the demand for assets: an asset is a piece of property that is a store of value. These include, inter alia, money, bonds, stocks, art, land, houses, farm equipment and manufacturing machinery. The following are the factors that will influence a person’s demand for assets:  Wealth: total resources owned by the individual, including all assets. Holding everything else constant (ceteris paribus), an increase in wealth raises the quantity demanded of an asset - positively related.  Expected return: on one asset relative to alternative assets. An increase in an asset’s expected return relative to that of an alternative asset, ceteris paribus, raises the quantity demanded of that asset - positively related.  Risk: (the degree of uncertainty associated with return) on one asset relative to other assets. Ceteris paribus, if an asset’s risk rises relative to that of alternative assets, the quantity demanded of that asset will fall - negatively related.  Liquidity: (the ease and speed whereby an asset can be turned into cash) relative to alternative assets. The more liquid an asset is relative to alternative assets, ceteris paribus, the more desirable it is and the greater will be the quantity demanded - positively related. The Theory of Portfolio Choice: therefore states that, ceteris paribus: (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 to its liquidity relative to alternative assets. 22 ECS 3701 Lecture Notes Nicolas Souvaris Supply and demand in the bond market One approach to the determination of interest rates looks at the supply and demand for bonds, to see how the price of bonds is determined. The demand curve for bonds: at different points on the demand curve, the price of a bond and its interest rate are inversely related. The demand curve for bonds shows the relationship between the price of bonds (and interest rate) and the quantity demanded. This is an inverse relationship and is illustrated by a downward sloping (negative) demand curve. The equation that would be used as a basis to the derivation of the demand curve for bonds may be written as (refer textbook, 10th edition, pg 134; 9th edition, pg 94): i = Re = Where i = interest rate = yield to maturity Re = expected return F = face value of discounted bond P = initial purchase price of the discount bond By substituting different prices, given a specific face value, it can be shown that as the price of the bond decreases, the interest rate increases or vice versa. This would enable one to plot the relevant demand curve for the specific bond onto a set of axes. Refer Figure 1 pg 134 (chapter 5). Make sure you can derive such a demand curve. NB: Pay careful attention to the information on the vertical axis, namely price of the bond and interest rate. Supply curve for bonds: in this case, when the price of bonds is low, fewer bonds will be supplied, because these bonds will have a higher interest rate. At a higher price more bonds will be supplied. There is a positive relationship between the price of bonds and the quantity supplied. [This implies a negative relationship between the interest rate and the quantity of bonds supplied – as the interest rate decreases (price of bonds increases) it becomes less costly to borrow by issuing bond.] Market Equilibrium price and quantity of bonds: in the bond market this is achieved when the quantity of bonds demanded is equal to the quantity of bonds supplied at a specific price. If the price of the bonds is above the equilibrium price, then the quantity of bonds supplied will exceed the quantity demanded (excess supply). This will cause the price of bonds to fall and force the price towards equilibrium price. If the price of bonds is lower than the equilibrium price, then the quantity demanded of bonds will be greater than the quantity supplied (excess demand). This will cause the price of bonds to rise and force the price up towards equilibrium price. This will continue until an equilibrium price is 23 ECS 3701 Lecture Notes Nicolas Souvaris reached. NOTE: this can also be expressed in terms of changes in interest rates because each price corresponds to a particular interest rate. NOTE: supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows. This asset market approach is the dominant methodology used by economists. Use the space below to draw a supply and demand curve for bonds and show how equilibrium in the bond market is reached. Figure 1pg 134: Supply and demand for bonds P Q Changes in equilibrium interest rates It is important to remember the difference between a movement along the curve and a shifting of the curve. If the price of a bond or the interest rate changes, the movement will be along the existing curve indicating a change in quantity demanded. A shift of the demand or supply curve indicates that the quantity demanded or supplied at each given price and interest rate has changed by some other factor besides the bonds price or interest rate. When this happens, there will be a new equilibrium for the interest rate. Factors that cause a shift of the demand curve: refer to table 2 PG 138 and record the effect of changes of each of the following determinants:  Decrease in wealth: a decrease in the demand for bonds  A decrease in the expected interest rate: increase in the demand for bonds 24 ECS 3701 Lecture Notes Nicolas Souvaris [Remember in this case the interest rate decreases, the price of the bonds increases and the opportunity for making a profit on the sale of the bonds increases]  An increase in expected inflation: when inflation is expected to increase, the demand for bonds will decrease because other assets become more attractive as a hedge against inflation. [When expected inflation rises, the supply curve shifts to the right and the demand curve shifts to the left. The result is that the equilibrium bond price decreases and the equilibrium interest rate rises. This in turn means that when expected inflation rises then interest rates also rise == Fisher effect.]  An increase in the riskiness of bonds relative to other assets: the demand for bonds will decrease.  The liquidity of bonds increases (more people traded bonds easier to sell bonds quickly) relative to other assets: demand for bonds will increase. Similarly, increased liquidity of alternative assets lowers demand for bonds. Factors that cause a shift of the supply curve: the following factors will cause a shift of the supply curve for bonds:  Expected profitability of investment opportunities: in a business cycle expansion, firms are more willing to borrow, the supply of bonds increases and the supply curve shifts to the right. Likewise in a recession, the supply of bonds decreases (fewer expected profitable investment opportunities) and the supply curve shifts to the left.  Expected inflation: an increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right. When the expected inflation increases, the real cost of borrowing, measured by the real interest rate, falls. 25 ECS 3701 Lecture Notes Nicolas Souvaris  Government budget: government issues bonds to finance government deficits, when the deficit is large, the government will issue more bonds and the quantity of bonds supplied at each price will increase. APPLICATION: (1) In a business cycle expansion, the amount of goods and services produced increases and so national income increases. Business will be more willing to borrow and the supply of bonds will increase. In addition the expansion is likely to increase wealth and therefore the demand for bonds will also increase. However, depending on whether the supply or demand curve shifts more, the new equilibrium interest rate is either higher or lower. Data says that we normally see a higher interest rate. (2) If expected inflation rises, the expected return on bonds relative to real assets falls for any given bond price and interest rate. Demand for bonds then falls and demand curve shifts left. The rise in expected inflation also shifts the supply curve right as the real cost of borrowing has declined. Fisher effect: when expected inflation rises, interest rates will rise. The Liquidity Preference framework: supply and demand in the money market for money An alternative method for determining the equilibrium interest rate, developed by John Maynard Keynes, is the liquidity preference framework. This framework uses the demand and supply of money to determine the prevailing interest rate. Money is a special type of asset: Keynes based the liquidity preference framework on the assumption that there are two main categories of assets that people use to store wealth: money and bonds. Therefore the total wealth in an economy must be equal to the sum of money and bonds. This can be expressed as follows: B s + Ms = Bd + Md Rewrite the equation to show how it is possible to illustrate that if the money market is in equilibrium, then the bond market must also be in equilibrium: B s _ B d = Ms _ Md 26 ECS 3701 Lecture Notes Nicolas Souvaris Simplifications (assumptions) of the liquidity preference framework: the demand and supply of bonds framework is easier to use when analyzing the effects from changes in expected inflation, while the liquidity preference framework is easier to use when analyzing the effects of changes in income, price level and the supply of money. This framework assumes the following:  Wealth is stored in a combination of money and bonds. Real assets are ignored.  Money has a zero rate of return. Bonds have an expected return equal to the interest rate (i). As the interest rate rises, ceteris paribus, the expected return on money falls relative to the expected return on bonds and so the quantity of money demanded will fall.  The concept of opportunity cost can also be used to explain why the demand for money and interest rates are inversely related. At a higher interest rate the opportunity cost of holding money is greater than it would be at a lower interest rate.  The supply of money is fixed by the central bank. The supply curve is vertical. Equilibrium in the money market implies equilibrium in the bond market: the position where the quantity of money demanded equals the quantity of money supplied occurs at the point of intersection of the demand and supply curves for money. If there is an excess supply of money (that is the interest rate is above the equilibrium interest rate) then people are holding more money than they desire and will want to buy bonds. They are therefore likely to bid up the price of bonds and the interest rate will fall towards the equilibrium rate. In the case of excess demand for money, people wish to hold more money and will therefore wish to sell bonds. As a result the supply of bonds will increase and the price will drop which will push the interest rate up towards the equilibrium rate. 27 ECS 3701 Lecture Notes Nicolas Souvaris Refer to Figure 8 pg 148 and use a graph to illustrate equilibrium in the money market. Interest Rate Ms 25 excess supply 15 = i excess 5 demand Md 0 Quantity of Money Changes in equilibrium interest rates in the liquidity preference framework Money Demand curve shifts because of:  Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.  Price-level effect: a rise in the price level causes the demand for money to increase and the demand curve to shift to the right. (people care about amount of money they hold in real terms) Money Supply curve shifts because of:  Changes in money supply: an increase in the money supply due to expansionary monetary policy implies that the supply curve for money will shift to the right. When the supply of money increases, ceteris paribus, the interest rate will decline (liquidity effect). When the supply of money decreases, ceteris paribus, the interest rate will rise. Assumption of all other factors being equal may not necessarily hold, given an initial increase in money supply, why? Refer to the section in the textbook, pg114. Milton Friedman acknowledged that the liquidity preference analysis is correct and referred to the fact that an increase in the money supply lowered the interest rate as the liquidity effect. However, he also noted that an increase in the money supply might nullify the ceteris paribus assumption. 28 ECS 3701 Lecture Notes Nicolas Souvaris This may be summed up as follows: “there are four possible effects of an increase in the money supply on interest rates: the liquidity effect, the income effect, the price-level effect and the expected-inflation effect. The liquidity effect indicates that a rise in money supply growth will lead to a decline in interest rates, the other effects work in the opposite direction. The evidence seems to indicate that the income, price-level, and the expected-inflation effects dominate the liquidity effect such that an increase in money supply growth leads to higher rather than lower interest rates” [Mishkin F, The economics of Money, Banking and Financial Markets. 2007. Boston: Pearson Education Inc.] C5 How is the interest rate determined in South Africa? Refer to the study guide and answer this question, pg 34. A: As far as the bond market is concerned, the demand and supply of assets that explained bond interest rates is a good approximation of reality in South Africa. However the liquidity preference theory does not apply in SA. The Reserve Bank cannot and does not control the money supply but rather the interest rate (repo). The level of the repo rate determines the demand for money – the amount the private sector wishes to borrow. Typical Examination questions 5.1 Briefly explain how four major factors affect the demand for an asset. (4x2=8) 5.2 Derive a bond demand curve (price of bond versus its quantity demanded) and a bond supply curve and explain how the equilibrium P and Q for the bond is determined using the asset market approach. Explain which curve may be associated with borrowers/lenders respectively. Illustrate graphically. (10) 5.3 Briefly explain the demand/supply for assets framework and then use it to predict (provide reasons) how the demand for and supply of bonds are affected by each of the following: a A business cycle expansion (also predict the equilibrium P,Q as well as i) (5) b An increase in the public's propensity to save (2) c Higher expected future interest rates (maturity of bond n1) (2) d An increase in the expected inflation rate (also predict the equilibrium P,Q) as well as i) (6) e An increase in the riskiness of bonds relative to other assets (2) f An increase in the government's budget deficit (2) 5.4 Explain Keynes' liquidity preference framework, that is, its simplifying assumptions, the derivation of the demand and supply curve and how equilibrium is determined. (8) 5.5 Explain how Keynes' liquidity preference framework can be used to explain the effects of an increase in income, a rise in the price level and an increase in the money supply (assume that all other economic variables 29 ECS 3701 Lecture Notes Nicolas Souvaris remain constant). Then explain why an increase in money supply does not necessarily lead to a decrease in interest rates over the longer term. (12) True or false review questions Bonds: Asset demand and supply 1. The demand curve for bonds indicates the willingness of lenders to buy bonds. If a lender buys a bond then the lender supplies funds to the borrower, which the borrower must repay over time. The price of bonds in figure 1 (p 134 of the prescribed text book) is the discount price the lender pays for the bond (the term discount bond applies in the case of a simple one-year bond). The lower the price, the greater is the discount, the higher is the interest rate (P=F/[1+i]) and the more willing lenders are to purchase bonds – and to supply funds to the issuers of bonds (the borrowers). 2. The supply curve for bonds indicates the willingness of borrowers to sell bonds. When a bond is sold to an investor, then the investor provides funds to the borrower. The price of a bond in figure 1 (p 134 of the prescribed text book) is what the borrower receives for the bond. The higher the price of bonds, the more the borrower receives and the lower the interest rate which the borrower must pay. 3. If the interest rate is expected to increase, then the price of bonds can be expected to fall. In the case of longer-term bonds, this may imply a lower return on bonds than initially expected. This will shift the demand curve for bonds to the left and the supply curve of bonds to the right. 4. A higher expected inflation rate will shift the demand curve for bonds to the left and the supply curve of bonds to the right. The demand curve will shift to the left because investors will be less willing to supply funds. The supply curve will shift to the right because this allows borrowers to obtain funds at a lower real cost. 5. The more liquid a bond, the more desirable it becomes for borrowers. 6. When a bond price increases, its yield also increases, because yield is calculated as a fixed percentage of price. 7. The Fisher effect unambiguously states that when the inflation rate is expected to increase, both the quantity and the price of bonds will decrease. 8. A business cycle expansion is likely to lead to a decrease in the supply of bonds because of a reduced need for bonds. Liquidity preference 9. When the central bank increases the money supply, the initial shortterm effect is that the supply curve of money shifts to the right, so that the interest rate falls. This is called the liquidity effect. 10. When the interest rate falls, then over time, this has an expansionary effect on the economy. When income increases, then the demand curve for money will shift to the right, which causes an increase in the interest rate. 30 ECS 3701 Lecture Notes Nicolas Souvaris 11. When income increases then this might also cause an increase in the general price level. The expected increase in inflation, according to the liquidity preference model, leads to an increase in interest rates. 12. The short-term expansionary effect of an increase in the money supply may thus be partly reduced or even completely overcome by longerterm increases in the interest rate due to the income and expectedinflation effects. 31 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 6: THE RISK AND TERM STRUCTURE OF INTEREST RATES Risk structure of interest rates Meaning of risk structure of interest rates: the relationship between interest rates on bonds with the same maturity. Factors such as risk, liquidity and income tax rules play a role in determining the risk structure of different bonds. Consider the factors that influence the risk structure:  Risk of defaulting: bonds that have no default risk are referred to as default-free bonds. The spread between default-free bonds and bonds with default risk is referred to as the risk premium. This refers to how much additional interest a bond must earn in order to make a person willing to hold it. A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium. [APPLICATION: refer to figure 2 on page 162 in the textbook to understand an application that illustrates the response to an increase in a default risk].  Liquidity of bonds: the more liquid an asset is the more people will wish to hold it. The greater the liquidity of a bond, the lower the interest rate required. The spread between a bond with high liquidity and one with low liquidity is also referred to as a risk premium.  Tax treatment: the fact that interest payments on municipal bonds in the USA are tax free has the same effect on the demand for these bonds as an increase in their expected returns. The demand for municipal bonds tends to be higher than a Treasury bond, even though they are riskier and less liquid, therefore prices are higher and interest rates have been lower (implying lower risk) than the Treasury bonds. Refer to figure 3 (9th pg 129, 10th ed. Pg 166). 32 ECS 3701 Lecture Notes Nicolas Souvaris 33 ECS 3701 Lecture Notes Nicolas Souvaris Credit rating agencies are important providers of information on risk premium. Term Structure of interest rates Another factor (aside from those considered above) that can influence interest rates is a bond’s term to maturity. Meaning of term structure: bonds with identical risk, liquidity and tax characteristics may have different interest rates because of different times remaining to maturity. Characteristics of yield curves: a plot of the yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations is called a yield curve. See pg 168.  When a yield curve slopes upwards (most common): long-term interest rates are above short-term interest rates  When a yield curve is flat: short- and long-term interest rates are the same. 34 ECS 3701 Lecture Notes Nicolas Souvaris  When a yield curve slopes downwards (inverted): long-term interest rates are below short-term rates. The following empirical facts relating to yield curves are also important: 1. Interest rates on bonds of differing maturities move together over time. See figure 4pg 169 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rate are high, yield curves are more likely to slope downwards and be inverted. 3. Yield curves almost always slope upward. Different theories: there are three theories that are used to explain the term structure of interest rates: 1. Expectations theory: “the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.” The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds that have this characteristic are said to be perfect substitutes – if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal. To prove this consider two investment strategies:  Purchase a 1-year bond and when it matures in one year, purchase another 1-year bond.  Purchase a 2-year bond and hold it until maturity Because both strategies have the same expected return, the interest rate on the 2-year bond must equal the average of the two 1-year interest rates. 35 ECS 3701 Lecture Notes Nicolas Souvaris The expectations theory is able to explain facts (1) and (2) above but is unable to explain fact (3). When the yield curve is upward sloping, the theory suggests that short-term interest rates are expected to rise in the future. 2. Segmented market theory: markets for different-maturity bonds are seen as completely separate and segmented. The interest rate for each bond with a different maturity is determined by the supply and demand for that bond, with no effects from expected returns on other bonds with other maturities. The key assumption in this case, is that bonds of different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond with another maturity. Investors have strong preferences for the bonds of one maturity but not for another, so they will be concerned only with the expected returns for bonds of the maturity they prefer. The segmented market theory is able to explain fact (3) above but is unable to give an adequate explanation for (1) and (2) as it views the market for bond of different maturities as completely segmented therefore there is no reason that a rise in interest rates for one bond would affect the rates of another maturity . 3. Liquidity premium theory (preferred): 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 plus a liquidity premium that responds to supply and demand conditions for that bond.” The key assumption is that bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors to prefer one bond maturity over another. Investors tend to prefer shorter-term bonds because of less interest-rate risk and so investors must be offered a liquidity premium to induce them to hold longer-term bonds. Closely related to this theory is the preferred habitat theory which assumes that investors will have choice preferences and will only be persuaded to move to another choice if they can expect higher returns. These two theories (liquidity premium and preferred habitat) combine the features of the expectations theory and the segmented market theory and are then able to explain all three facts relating to yield curves. They view long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond plus a liquidity premium. Note:  please read over Application: Interpreting yield curves on pg 178  from SG, go through additional explanation of SA yield curves on pg 30 36 ECS 3701 Lecture Notes Nicolas Souvaris Typical Examination questions 6.1 Explain the meaning of the risk structure of interest rates. List and explain the three factors which affect the risk structure of interest rates using a supply of/demand for bonds-framework. (18) 6.2 Explain the meaning of the term structure of interest rates and the yield curve. Draw a normal yield curve and explain why its shape applies. List three empirical observations of the yield curve. (10) 6.3 Explain the assumptions and predictions of the expectations theory and how well it explains the three empirical observations of the yield curve. (9) 6.4 Explain the assumptions and predictions of the segmented market theory and how well it explains the three empirical observations of the yield curve. (7) 6.5 Explain the assumptions and predictions of the liquidity premium theory of the term structure and the preferred habitat theories of the term structure and how well they explain the three empirical observations of the yield curve. (18) True or false review questions For each of the following questions, which one of the options is the most correct? 1. The risk structure of interest rates explains why the interest rate on bonds differs because the (a) quality of bonds are different although their time to maturity is similar (b) time to maturity is different but their quality is similar 2. The R157 bond was issued during 2005 and it matures in September 2015. In March 2009, the term to maturity of the R157 bond was approxima