FIN 4520 - HOW INTEREST RATES ARE DETERMINED

Market equilibrium:

The equilibrium price is such that the quantity supplied equals the quantity demanded.

Two approaches:

Bond supply and demand ("loanable funds") -- or:

Money supply and demand ("liquidity preference")

Demand for bonds: see previous handout for four factors

Supply of bonds is affected by:

1. Expected return relative to other assets (+)

2. Expected inflation (+)

3. Government actions

Demand for money is affected by:

Income (+)

Price level (+)

Supply of money is targeted by government policy. Effect on interest rates:

1. Liquidity effect

2. Income effect

3. Price-level effect

4. Expected inflation effect

What's the direction of each effect? Which effects are strongest?