Hi, I am reading interest rates and inflation section in the Economics volume. I have two questions and would be pleased if anyone could answer them: - The book says: “If the demand for bonds would rise, the price of bonds would rise, and the nominal interest rate would fall.” Why would nominal interest rate fall? - Again, the book says: “The real interest rate is determined in the capital market and the nominal interest rate is determined in the money market.” What does this sentence mean? What is the difference between these markets? Thanks!
Say the bond already has a face value of 1000, if the demand is high, investors bid up the price, meaning you earn a lower yield if you bought the bond and held it to maturity. For the second question… I don’t know how to explain it directly, but I usually remember it as real interest rate = nominal interest rate - inflation, and real interest rate is usually constant.
I’ll give this a shot, but certainly welcome input from someone else w/ more FI experience. I don’t like the phrasing of the first quote at all. Like yickwong, the first thing that comes to mind is the inverse relationship between bond prices and yield. This part’s pretty straight-forward: yield = coupon payment / bond price As that denominator gets bid up, we can clearly observe the resulting decline in yield. So but the quote uses “nominal interest rate” and it’s unclear to me, particularly out of context, whether this is an attempt to convey some broader phenomenon, like, if the demand for bonds rises (i.e. the supply of loanable funds increases), nominal interests rates will generally decline for new issues unless demand for loanable funds increases proportionally. Basic supply and demand here. Is that what this quote’s about? I don’t know. Second quote, I’m going to have to speculate a little more and invite the derision our brighter AF colleagues. First let’s define our markets. “Capital market” is awfully vague, so I’ll work under the assumption it means the market for long-term debt securities (specifically, original maturities greater than one year), which stands in contrast to the money market, which we can more precisely define as the market for short-term debt securities like commercial paper, bankers acceptances, and Treasury Bills. Okay, going out on a limb here, my understanding is that the money market has much higher liquidity than the market for longer-maturity debt securities. Let’s assume for a moment that I’m correct, and that we’re confining our discussion to a developed economy with low-to-moderate inflation, then I wouldn’t expect inflation to be a material concern to money-market participants, who could quote rates in nominal terms and be confident their nominal returns are approximately equivalent to the real return (inflation-adjusted). Moreover, I would expect the money market’s liquidity to furnish us with a more accurate gauge of true borrowing costs, albeit short-term rates for high credit-quality issuers. Moving along… as we consider longer-maturity debt securities, inflation becomes a more material concern. Each successive fixed coupon payment declines in real value as inflation occurs. I’m banking on the assumption here that investors in this longer-maturity debt market factor expected inflation into their required rate of return, allowing us to derive a true “real interest rate” by adjusting the quoted nominal rates for expected inflation. yickwong, one nit-picky point. Just to clarify, your formula for calculating the real interest rate is a linear approximation. Here’s the precise calculation, even though they’re close, it’s good to know both and cite them accordingly. 1 + R_nominal = (1 + R_real)*(1 + Inflation) 1 + R_real = (1 + R_nominal)/(1 + Inflation) R_real = [(1 + R_nominal)/(1 + Inflation)] - 1 minocfa, I sure would like to see the broader context of these two quotes. If you’re up to it, maybe type a bit more of the surrounding text and/or share some of that chapter’s LOS. Quotes like this piss me off, they just convey facts that the reader is supposed to take for granted as being true w/o provision of any further explanation. Please correct me (politely, please) if I’m mistaken, folks, thanks.
Thank you all for your answers. I have taken these sentences from Economics Book (Volume 2), pages: 419-421. They are under “Interest rates and Inflation” title. I am giving more of the surrounding text for the first one: - " To see why the nominal interest rate equals the real interest rate plus the expected inflation rate, think about the investment, saving and demand for money decisions that people make. Imagine first there is no inflation and none is expected. Investment equals saving at a real interest rate of 6 percent a year. WD Corporation is willing to pay an interest rate of 6 percent to get the funds it needs for its investment in a new park. If the nominal interest rate was 7 percent, WD would put its investment plans on hold and buy bonds. It would make an extra one percent interest by doing so. As WD and others bought bonds, the demand for bonds would increase, the price of bonds would rise, and the nominal interest rate would fall. Only when the nominal interest rate on a bond equaled the real interest rate on a new park would WD be in equilibrium. " - The text for the second one: “Investment demand and saving supply determine the real interest rate in the market for financial capital. Investment demand and saving supply depend on the real interest rate. The demand for money and the supply of money determine the nominal interest rate in the money market. The demand for money depends on the nominal interest rate, the supply of money is determined by the Fed’s monetary policy. Because the real interest rate is determined in the capital market and the nominal interest rate is determined in the money market, it might seem that there is no connection between them. But there is a very tight connection. On the average, the nominal interest rate equals the real interest rate plus the expected inflation.”
Why make this difficult? People buy bonds…prices go up…yields go down