Interest and Bond Prices

To get the idea how this works, let's think about a simpler kind of monetary system. First, we suppose that monetary assets get no interest at all. (That was true in the U. S. until the 1970's). Second, suppose the only other asset besides money is bonds. The bonds were issued in units of 1000 and pay interest of 6%, that is, $60 on a $1000 bond. Here's a figure:

Figure 3. Liquidity Preference

The quantity of money is Ms. Suppose the interest rate is R1 = 6%. At that interest rate people want to shift Ms minus M1 of their assets from money into bonds. Thus they increase the demand for bonds, and that pushes the price of bonds up. Suppose the price of bonds goes up to $1200. Then the rate of interest is $60/$1200 = 5% -- the higher price of bonds means a lower rate of interest on bonds. Thus the competition for scarce bonds pushes the interest rate down below R1.

But suppose the price of bonds were to rise very high, say to 2000, so that the rate of interest would be $60/2000 = .03 = R2. At that rate of interest, people want to shift M2 minus Ms of their assets from bonds to money. That is, they want to sell that amount of bonds. But the competition to sell the bonds will push the price of bonds down below 2000, and so the interest rate will rise above R2.

We see that competition will always push the interest rate toward the intersection of the Liquidity Preference Curve with the money supply.


Next:Changes in The Supply of Money
Copyright