8. DETERMINING THE MARKET INTEREST RATES
We explain in this chapter which factors determine interest rates by using the market forces
of supply and demand for bonds. Furthermore, several factors shift the supply and demand
functions, which alter the bond's market quantity, market price, and market interest rate. These
shifts allow analysts and economists to predict changes in the interest rates and bond prices.
Moreover, we use demand and supply functions to explain interest rate behavior during business
cycles and recessions and explain the Fisher Effect. Finally, we introduce a loanable funds
market for a small country. Then we expand the supply and demand for bonds to include a
world’s real interest rate. Consequently, the world's interest rate either causes loanable funds to
enter or leave a small country.
The Supply and Demand for Bonds
Interest rates have fluctuated substantially in the United States during the second half of the
20th century. For example, interest rates on 3-month T-bills were 1% in the early 1950s. Then,
the interest rates on T-bills soared to over 15% in 1981 and subsequently, plummeted to below
6% in the mid-1980s and 1990s. Currently, T-bill rates have fallen below 1% after the 2008
Financial Crisis.
Everyone closely watches the interest rates. They determine whether consumers should save
or buy, whether families should buy a house or purchase bonds. Furthermore, the interest rates
influence business decisions to invest in new equipment or invest their money into financial
securities. From Chapter 2, you have learned the major financial instruments. All these
instruments represent credit market instruments. All these instruments are loans, where one
party lends funds to another party except corporate stock. Stock conveys ownership in a
corporation and is not a loan.
Companies and governments issue a variety of credit instrument with different maturities.
Therefore, each credit instrument has an interest rate associated with it. Financial markets have
hundreds of financial instruments, which create hundreds of interest rates. Good news is all
interest rates usually move together. If one interest rate increases, then the other interest rates
rise too. For our analysis, we assume a market has one interest rate.
Bond’s supply and demand determine the interest rate in the bond market, and a bond
becomes the tradable commodity. Investors buy bonds while businesses and government supply
bonds. Consequently, the intersection of supply and demand functions in the bond market
determines the bond’s market price and quantity.
Demand function reflects the relationship between the quantity demanded and the market
price of bonds, when we hold all other economic variables constant. We show a demand
function in Figure 1. Demand function has a negative slope because as you move from point A
to point B, the price of bonds becomes lower, so investors buy more bonds for a cheaper price.
Just imagine bonds are similar to a product. For example, if the price of a soda becomes
cheaper, then consumers buy more sodas. Please note as you move from point A to point B, the