The post war data imply that prices of long term discount bonds are more variable than those of short term discount bonds and that long term interest
rates, measured by yield-to-maturity, are less volatile than short term rate. In addition, we find that short-term interest rate are procyclical, while lay-term interest rates vary little with current output. What economic factors influence interest rate variability? If we can isolate some economic determinants of the levels of interest rates, and bond prices, we will b e well on our way to funding determinants of this variability.
DETERMINATION OF SHORT-TERM ENTERPRISES: A standard economic model will help us think about how the interest rate on short term discount bonds is determined. Let’s consider the case of a discount bond that will pay off $100 with certainty in one year. Suppose a prospective bond buyer expects her real income over the coming year to be higher than usual (real income refers to income adjusted for any change in the general level of prices over time). In that case, she has less of an incentive to increase her savings by purchasing a bond today. In fact, she may well decide to borrow against some of her expected increase in income. If all prospective bond purchasers expected high real income over the coming year, demand for current one-year bonds will fall, and their prices will fall as well, which means that the one year interest rate will rise. On the other hand, investor may decide to hedge against the risk of lower future income by purchasing bonds today that provide a guaranteed future pay off. If current real output (can thus aggregate real income) is low, investors may expect future output to be low, because there is some persistence to output movements. Hence a downward movement in current output is consistent with a downward movement in current short-term interest rates if people expect output and income
in the near future to be low as well. This theory is consistent with procyclical movement in short-term interest rate.
The yield curve tends to flatten when output is high and tends to steepen when output is low. Suppose we are currently in a boom, but people expect recession in one year. Investors may buy one year bonds to hedge the risk of low future income, and they may pay for these bonds, in part by cashing in their shorter- term assets. This portfolio reallocation tends to lower one- year interest rate and raise shorter-term interest rates, this leading to a flatter yield curve. Empirical studies have found that the shape of the yield curve does help predict recessions and expansions.
Expected inflation is also a determinant of interest rates. Consider against case of a discount bond that pays $100 with certainty in one year. Suppose now that prospective bond purchasers expect inflation to rise over the coming year. When inflation rises, the curved price of one year bonds will fall because investors realize that their dollars buy less when prices rise. For example, if the price of a cup of coffee one year from now is $1, bond holders can buy low cups of coffee with the $100 that the bond pays off. But if the price of a cup of coffee is expected to rise to $1.05, bond holders will be able to buy only 95 cups of coffee. To be compensated for the loss in
Purchasing power, investors must get a higher dollar return on their investments. Thus, bond prices will fail and interest rates will rise when expected inflation rises (Harvey 1993).
This model suggests that when expected income or expected inflation rises, bonds prices will fail. This fall in bond prices translates into higher interest rates. So, when we think about how short term interest rates are determined, we want to think about people’s forecast for real income growth and inflation. Any current economic variables that helps to predict real income growth and inflation will help to determine current short time bond prices and interest rates.
DETERMINATION OF LONG TERM INTEREST RATES: Long term interest rates can be linked to short term interest rate by the expectation theory of the term structure. This theory says that long term interest rates are equal to an average of expected short-term interest rates plus a risk premium. The risk premium accounts for the co-variation over time of variable like income growth and inflation that could influence the level of interest rates.
The logic of the expectation theory of bond prices is most clearly seen in an example in which we ignore the risk premium. Take the case of an investor who has a two year investment horizon. The investor can purchase two year bond, or he can purchase a one-year bond today and, when that bon mature, purchase another one year bond. The expected return on there alternative investment strategies should be equal. Since there is a direct relationship between interest rates on bonds and bond prices, the expectations theory also links long-term discount bond prices to expected short-term discount bond prices over the life of the long term bond.
In terms of expected future short term bond prices, the same variables that affect short term bond prices basically determine long term bond prices and interest. Thus, expected future income growth and expected inflation are also determinants of long term bond prices, but now the forecasts of income growth and inflation are for further in the future it is till the case that if over the life of the bond, expected future incorQe growth or expected future inflation rises, long term interest rates will rise. Including a risk premium does not alter these basic conclusions about the determinants of interest rates. However, the risk premium can be an additional source of variability for interest rates because it picks up some induced effects of income growth and inflation on interest rates as well as other risk factors, (chatterjee (1995).
This model helps us think about why long-term interest rates co-vay less with current output than do short-term interest rates. Current movements in real output are much more closely current movements in reI output are much more closely corrected with output movements in the near future than they are output movements in the far future. Since the payment steam on a long term bon extends further out into the further than that on short term bond, long-term interest rates are less likely to have a strong covariation with current output movements. Determinants of interest rates and the prices o bonds also determine the volatilities of interest rates and bond prices. This economic model suggests that expected real income growth and expected real income growth and expected inflation determine bond prices and interest rates. If follows that the
volatility of expected real income growth and the volatility of expected inflation, as well as the correlation between the two, determine the volatility of interest rates and bond prices.
The reasoning behind this conclusion is straight forward. Take the case of real income growth. We saw above that if real income growth is expected to be high, current bond prices will fall and interest rates will rise, the higher real income growth is expected to be, the higher interest rates will be. This large changes is expected real income growth are associated with large changes in interest rate. When real income growth has high volatility, large changes in real income growth occur more frequently, and hence large changes in current bond prices and interest rates occur ore frequently. When large change in interest rates occur more often, interest rates are more volatile. Similar reasoning holds for the case of inflation. When large changes in expected inflation occurs laye, changes in current bond prices and interest rates occur also. So, more volatile inflation translates into more volatile bond prices and interest rates (Sill 1994).
What determines how volatile income growth and inflation will be? One factor is monetary policy. Take the case of monetary policy and inflation. Economists generally believe that a persistent inflation has its root causes in monetary policy, in particular, how fast the money supply grows relative or real income growth. If growth of the money supply is excessive, inflation, highly volatile growth in the money supply can lead to volatile inflation. This does not mean that every
change in the money supply necessarily leads to a change in inflation: Rather, if on average, money supply growth becomes more volatile, inflation can become more volatile as well. As we have seen, the model than suggests that bond prices and interest rate will also be more volatile. King et al (1993).
Monetary policy could also have an effect on real income, although economists disagree on the mechanism by which this occurs. One theory is that workers write contracts with their employers that fix a nominal wage rate over the contract period. Workers and firms negotiate the contracted wage based, in part, on their expectations of what inflation will be over the contract period. Since monetary policy affects inflation, this requires workers and firms to forecast what monetary policy will be over this same period. If monetary policy and the price level turn out to be different from what workers and firms expected. When they wrote the contract employment and output could be affected because firm’s demand for workers depends on the real wage rate that must be paid. If nominal wages are fixed by a contract and prices rise unexpectedly, read wages fall, and firms demand more workers and produce more output. If prices fall unexpectedly, real wages rise, firms layoff workers and output falls. Thus, variability of the money supply, through its impact on prices, could have an impact on the variability of real income.
Economic models and interest Rate volatile: This economic model for determining bond prices and interest rates suggests that investors expectations of future real income growth and inflation are the primary determinates of current
bond prices and interest rates. There are, of course, other determinates of interest rates and interest rate volatility in the economy. But we can try to asses how well this view of interest rate determination explains the interest rate volatility that we observe in the actual economy.
One approach to assessing how well a model performs is to use the model to simulate interest rates and then compare the properties of the simulated interest rates to the properties of actual interest rates. For example, we can set up models and use them to simulate price data on discount bonds for various maturities. We can then calculate the standard deviation of these simulated data and compare it to the standard deviation of deviation of discount bond prices implied from the interest rate we observe in the economy. We can also examine how the simulated bond prices and interest rates co-ray with simulated output and compare the correlations to the correlations we find in the actual data. In this way, we can access the ability of the model to account for the cycled volatility of interest rates.
A lot of researchers and authors have studied investment decision in different research in sure.
rates, measured by yield-to-maturity, are less volatile than short term rate. In addition, we find that short-term interest rate are procyclical, while lay-term interest rates vary little with current output. What economic factors influence interest rate variability? If we can isolate some economic determinants of the levels of interest rates, and bond prices, we will b e well on our way to funding determinants of this variability.
DETERMINATION OF SHORT-TERM ENTERPRISES: A standard economic model will help us think about how the interest rate on short term discount bonds is determined. Let’s consider the case of a discount bond that will pay off $100 with certainty in one year. Suppose a prospective bond buyer expects her real income over the coming year to be higher than usual (real income refers to income adjusted for any change in the general level of prices over time). In that case, she has less of an incentive to increase her savings by purchasing a bond today. In fact, she may well decide to borrow against some of her expected increase in income. If all prospective bond purchasers expected high real income over the coming year, demand for current one-year bonds will fall, and their prices will fall as well, which means that the one year interest rate will rise. On the other hand, investor may decide to hedge against the risk of lower future income by purchasing bonds today that provide a guaranteed future pay off. If current real output (can thus aggregate real income) is low, investors may expect future output to be low, because there is some persistence to output movements. Hence a downward movement in current output is consistent with a downward movement in current short-term interest rates if people expect output and income
in the near future to be low as well. This theory is consistent with procyclical movement in short-term interest rate.
The yield curve tends to flatten when output is high and tends to steepen when output is low. Suppose we are currently in a boom, but people expect recession in one year. Investors may buy one year bonds to hedge the risk of low future income, and they may pay for these bonds, in part by cashing in their shorter- term assets. This portfolio reallocation tends to lower one- year interest rate and raise shorter-term interest rates, this leading to a flatter yield curve. Empirical studies have found that the shape of the yield curve does help predict recessions and expansions.
Expected inflation is also a determinant of interest rates. Consider against case of a discount bond that pays $100 with certainty in one year. Suppose now that prospective bond purchasers expect inflation to rise over the coming year. When inflation rises, the curved price of one year bonds will fall because investors realize that their dollars buy less when prices rise. For example, if the price of a cup of coffee one year from now is $1, bond holders can buy low cups of coffee with the $100 that the bond pays off. But if the price of a cup of coffee is expected to rise to $1.05, bond holders will be able to buy only 95 cups of coffee. To be compensated for the loss in
Purchasing power, investors must get a higher dollar return on their investments. Thus, bond prices will fail and interest rates will rise when expected inflation rises (Harvey 1993).
This model suggests that when expected income or expected inflation rises, bonds prices will fail. This fall in bond prices translates into higher interest rates. So, when we think about how short term interest rates are determined, we want to think about people’s forecast for real income growth and inflation. Any current economic variables that helps to predict real income growth and inflation will help to determine current short time bond prices and interest rates.
DETERMINATION OF LONG TERM INTEREST RATES: Long term interest rates can be linked to short term interest rate by the expectation theory of the term structure. This theory says that long term interest rates are equal to an average of expected short-term interest rates plus a risk premium. The risk premium accounts for the co-variation over time of variable like income growth and inflation that could influence the level of interest rates.
The logic of the expectation theory of bond prices is most clearly seen in an example in which we ignore the risk premium. Take the case of an investor who has a two year investment horizon. The investor can purchase two year bond, or he can purchase a one-year bond today and, when that bon mature, purchase another one year bond. The expected return on there alternative investment strategies should be equal. Since there is a direct relationship between interest rates on bonds and bond prices, the expectations theory also links long-term discount bond prices to expected short-term discount bond prices over the life of the long term bond.
In terms of expected future short term bond prices, the same variables that affect short term bond prices basically determine long term bond prices and interest. Thus, expected future income growth and expected inflation are also determinants of long term bond prices, but now the forecasts of income growth and inflation are for further in the future it is till the case that if over the life of the bond, expected future incorQe growth or expected future inflation rises, long term interest rates will rise. Including a risk premium does not alter these basic conclusions about the determinants of interest rates. However, the risk premium can be an additional source of variability for interest rates because it picks up some induced effects of income growth and inflation on interest rates as well as other risk factors, (chatterjee (1995).
This model helps us think about why long-term interest rates co-vay less with current output than do short-term interest rates. Current movements in real output are much more closely current movements in reI output are much more closely corrected with output movements in the near future than they are output movements in the far future. Since the payment steam on a long term bon extends further out into the further than that on short term bond, long-term interest rates are less likely to have a strong covariation with current output movements. Determinants of interest rates and the prices o bonds also determine the volatilities of interest rates and bond prices. This economic model suggests that expected real income growth and expected real income growth and expected inflation determine bond prices and interest rates. If follows that the
volatility of expected real income growth and the volatility of expected inflation, as well as the correlation between the two, determine the volatility of interest rates and bond prices.
The reasoning behind this conclusion is straight forward. Take the case of real income growth. We saw above that if real income growth is expected to be high, current bond prices will fall and interest rates will rise, the higher real income growth is expected to be, the higher interest rates will be. This large changes is expected real income growth are associated with large changes in interest rate. When real income growth has high volatility, large changes in real income growth occur more frequently, and hence large changes in current bond prices and interest rates occur ore frequently. When large change in interest rates occur more often, interest rates are more volatile. Similar reasoning holds for the case of inflation. When large changes in expected inflation occurs laye, changes in current bond prices and interest rates occur also. So, more volatile inflation translates into more volatile bond prices and interest rates (Sill 1994).
What determines how volatile income growth and inflation will be? One factor is monetary policy. Take the case of monetary policy and inflation. Economists generally believe that a persistent inflation has its root causes in monetary policy, in particular, how fast the money supply grows relative or real income growth. If growth of the money supply is excessive, inflation, highly volatile growth in the money supply can lead to volatile inflation. This does not mean that every
change in the money supply necessarily leads to a change in inflation: Rather, if on average, money supply growth becomes more volatile, inflation can become more volatile as well. As we have seen, the model than suggests that bond prices and interest rate will also be more volatile. King et al (1993).
Monetary policy could also have an effect on real income, although economists disagree on the mechanism by which this occurs. One theory is that workers write contracts with their employers that fix a nominal wage rate over the contract period. Workers and firms negotiate the contracted wage based, in part, on their expectations of what inflation will be over the contract period. Since monetary policy affects inflation, this requires workers and firms to forecast what monetary policy will be over this same period. If monetary policy and the price level turn out to be different from what workers and firms expected. When they wrote the contract employment and output could be affected because firm’s demand for workers depends on the real wage rate that must be paid. If nominal wages are fixed by a contract and prices rise unexpectedly, read wages fall, and firms demand more workers and produce more output. If prices fall unexpectedly, real wages rise, firms layoff workers and output falls. Thus, variability of the money supply, through its impact on prices, could have an impact on the variability of real income.
Economic models and interest Rate volatile: This economic model for determining bond prices and interest rates suggests that investors expectations of future real income growth and inflation are the primary determinates of current
bond prices and interest rates. There are, of course, other determinates of interest rates and interest rate volatility in the economy. But we can try to asses how well this view of interest rate determination explains the interest rate volatility that we observe in the actual economy.
One approach to assessing how well a model performs is to use the model to simulate interest rates and then compare the properties of the simulated interest rates to the properties of actual interest rates. For example, we can set up models and use them to simulate price data on discount bonds for various maturities. We can then calculate the standard deviation of these simulated data and compare it to the standard deviation of deviation of discount bond prices implied from the interest rate we observe in the economy. We can also examine how the simulated bond prices and interest rates co-ray with simulated output and compare the correlations to the correlations we find in the actual data. In this way, we can access the ability of the model to account for the cycled volatility of interest rates.
A lot of researchers and authors have studied investment decision in different research in sure.
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