43. Behavior of Interest Rate - 2

Added: 2026-05-07

[00:00:18]Hi and welcome back.

[00:00:21]We are learning the bonds and bond pricings in which we are learning the behavior of interest. We have already understood the factor determining the bond pricing.

[00:00:38]Okay, that is what are the factors that determine the demand for bonds? We have already understood and now in this session we are going to discuss what are the factors that determine the supply of bonds and also eventually we are going to discuss you know the impact of interest rate during the recessions.

[00:01:06]Okay. So now we have already understood that any changes in the factors other than the price factor of the bond will shift the demand for bond curve. For example, the factor or the other factor that determining the demand for bonds are wealth, right? Expected rate of return or expected real return and the risk of the bond and also the liquidity of the bond. Okay. So, so the riskiness of the bond actually will have negatively related to the demand for bond. Okay. And the other factors that are wealth and the expected return rate and liquidity all are actually positively influence the demand for bond and therefore the changes in these variables will cause the shift of the demand curve to the right. Okay. Now let us discuss the factor determining the supply curve. But for no but but now let's understand why does the supply curve of the bond slope upward. Remember we have you know drawn a supply of bond curve that slopes upward. But why? Okay the answer is very simple here. As the price of bond increases, okay, or their yield decreases, the bond issuer will want to issue more bond because the yield or the interest rate they have to pay to bond holder has actually decreased. That means the borrowing cost of the bond issuer actually declines.

[00:03:00]Right?

[00:03:02]Okay. Means whenever the you know so when price increases okay borrowing cost of the bond will decrease and therefore the issuer actually issue more bond okay and therefore supply of bond is likely to increase. There is a positive relationship between the supply of bond and the price of bond. That is the reason the supply curve slopes upward.

[00:03:33]Okay.

[00:03:36]So let us now discuss what are the factors other than the price factors okay that influence the supply of bond. Several factors okay influence the supply of bond. Okay. One of such is like business expectation for the profitability of investment or expected future profit or we will say like you know if the firm expect okay in the near future it is going to be more profit or more profitable okay or its investment will actually enable it to get more profit then what will happen to supply of phone Okay. So if farms are more optimistic about the future that is if the firm expect it can make more profitable investment then firm will be willing to borrow borrow more to finance their investment. Okay.

[00:04:40]And that is the reason it is expected that farm will go for more debt financing and you know they will issue or they will likely to issue more you know like another factor which is very very important is the expected inflation. Okay.

[00:04:58]So remember that if you think there will be inflation in the future you want to borrow more now. Okay. Why? Because inflation reduce the real cost of debt.

[00:05:12]Okay. How inflation will reduce the real cost of debt? Imagine you have 1,000 rupees debt and you earn 200 rupees per hour. Okay? So you earn per hour 200 rupees and you have actually a debt of 1,000 rupees to pay up. Right? So that means you have to work okay at least 5 hours to pay off the debt. Now imagine that there is an inflation and therefore your wage is likely to increase. Okay?

[00:05:52]But the amount of your debt does not go up with inflation. Right? So now your wage is suppose let's say 250 per hour.

[00:06:04]Okay? So because of the inflation you are now expecting your wage to you know like 250 per hour and therefore you require only 4 hours to work okay to get 1,000 rupees to pay off your debt cost.

[00:06:22]Therefore the real cost of the debt has declined with an increase in inflation.

[00:06:30]Okay. So what we have understood here is that the real cost of the debt has declined with an increase in inflation.

[00:06:40]Okay.

[00:06:42]So what does it mean? It means that okay so it means whenever you like people expect more inflation okay then people want to borrow more that essentially means that okay they will go for the debt financing and they will issue more bond. So higher expected inflation will lead the issuer to issue more bond. Okay.

[00:07:18]Another one is government budget deficit. Okay. What happened? Remember that not only farm will require money for its finance but government also require money for it financing purpose and therefore there are two roots for the government. one is tax and another one is to incur the debt. So government issues bond to finance its expenditure.

[00:07:46]Okay. Therefore an increase in government budget deficit. Okay. An increase in government budget deficit lead the government to issue more bond.

[00:07:58]So the supply of bond in the market will increase. So higher the government deficit or the higher the budget deficit higher the supply of bond. Okay.

[00:08:15]Another one is corporate tax. What happened when the government actually impose more? Remember usually okay or theoretically you can believe you know you believe that a tax increase may reduce farm profitability of investment. Okay it is expected right a tax increase okay is likely to reduce firm profitability of investment and therefore firm will actually demotivate to you know issue bomb. If that happens then it will inversely influ or it will negatively influence the supply of bond. However, if the interest payment on the corporate tax okay or if the interest payment on the corporate bonds are tax deductible we call it tax sealed. Okay.

[00:09:11]If that happen then the corporation may issue more to take this advantage okay and it happens also okay like in practice we expect firm to you know like go more on you know debt financing to take the advantage of this you know like tax shield or interest payment on corporate bonds are tax deductible right so if that happen then we will expect the corporate tax may increase the supply of bond. So both can happen in case of tax.

[00:09:52]Okay.

[00:09:55]So what you have understood here all these variables actually will you know like shift the supply of bond curve either to right or to left. Okay. So holding constant all other factors okay including the price expected profitability of investment opportunity will shift the curve to or shift the supply curve to right. Okay.

[00:10:26]And expected inflation rate is also you know our changes in expected inflation rate will actually shift the supply curve to right. Same you know like apply it to you know like corporate sorry the government deficit or the government budget deficit also. But in case of business tax or the corporate tax okay tax reduce the profitability of investment and therefore an increase in business tax reduce the supply of bond the supply curve will shift to left.

[00:10:59]Okay. However, if the interest payments in corporate on corporate bonds are tax deductible then supply to a right. Okay.

[00:11:11]So now you have understood that both you know like factor that are determining the demand for bonds and the factors that are determining the supply of. And now in equilibrium therefore supply is supposed to be equal to demand for bond.

[00:11:37]Okay. Now so before entering into more on the behavior of interest rate let us also okay this is my favorite question although right why does one deserve interest payment. We must understand the importance of interest rate. I believe you have already you know like learned this okay from the starting itself. But again now let us for the time you know like uh remember whatever we have learned here why does one deserve the interest payment. Okay you know like most of the time two factor or two reasons actually can answer us why the why our saving deserve the interest payment. One is the presence of inflation. Okay. One one is the presence of inflation. So your one rupee can buy more today in terms of real goods than in the future. And therefore you demand an interest. Okay?

[00:12:45]Or you demand an interest rate to compensate for the loss of your purchasing power. Right?

[00:12:53]Second one is like most of the time people prefer consum you know like present consumption to future consumption right so our present consumption is more important than future consumption okay and therefore to get you to postpone the consumption for the future the borrower must offer okay some compensation in the form of an interest rate and this happens even without the inflation. Okay. Or in the absence of inflation also this can be possible, right? So because you know like you are very much interested in current consumption the moment you are agreed to lend money. Okay, that means that you are postponing your present consumption to sometime in the future and therefore the borrower need to compensate you okay for this purpose right or in the form of an interest rate.

[00:13:59]Okay, of course you know like how strong your preference is actually matter here.

[00:14:05]Okay. So how much do you need to be offered? Okay. Depends on how strong your preference okay for cons you know current consumption is. Higher this preference higher will be the interest rate. Okay. So we will say that much you know the stronger the preference okay higher will be the interest rate because it is so important but you still you know are ready to postpone your current consumption to future and therefore you may require a higher interest rate in this case. Right? So there are at least two reason why our savings deserve the interest payment.

[00:14:54]Okay.

[00:14:57]Okay. So let us also understand what is nominal and what is real interest rate.

[00:15:04]Of course again like you know like probably during the time of you know annuity and you know like other discussion you probably have already discussed it but again just recall it whatever we have discussed. So nominal interest rate is basically the interest rate in terms of the monetary value.

[00:15:24]Okay. On the other hand, the real interest rate, the interest rate in terms of the baskets of goods or in terms of how much goods and services you are going to get, okay, or purchase, okay, with the same, right? So interest rate is adjusted by subtracting expected change in the price level so that it more accurately reflect the true cost of borrowing.

[00:15:58]Okay.

[00:15:59]So the real interested reflect the rate of time okay or rate of time preference for current goods over the future goods right so it reflect the change in the purchasing power. So the real interest rate actually will reflect the change in the purchasing power and therefore okay people most of the time okay worried about the real interest rate and not the nominal interest rate. Okay.

[00:16:32]Right. So let us understand a very you know like famous concept in economics as well as in this concept here which is known as phaser effect. Okay. So what is the fiser effect and what is the fer equation? The fer effect basically tells us that the expected inflation and the nominal interest rate will tend to move together over time. Okay. So as the expected inflation increases the nominal interest rate also will increase okay over the time right. So we can just simply rewrite this equation as you know like nominal interest rate representing small I okay which is equal to the real interest rate R. Okay, remember that this R here actually we are talking about the real interest rate. Okay, the different from the coupon rate what we have used here but concentrate on this class you know like actually and then we will you know like understand this R the real interest rate and this I is the nominal interest rate okay plus the expected inflation whatever inflation you are expecting. So what is inflation?

[00:17:48]By the way, the changes in the price level or the aggregate price level is actually known as inflation, right?

[00:18:00]Which can be measured by the you know like wholesale price index or consumer price index or GDP deflator. Okay. And the inflation can be measured as simply the change or the growth the WPI or the CPI or GDP deflator. So this equation can also be written in terms of real interest rate. So we will write in terms of real interest rate as real interest rate is equal to nominal interest rate minus expected inflation. So what does this equation mean? This is the very very famous equations and very much applicable also. Okay. An increase in the expected you know like inflation rate lower the expected real interest rate. Okay. So and whenever inflation or expected inflation increases it will actually decrease the real interest rate.

[00:18:58]Okay.

[00:19:00]So no. So this equation actually have you know like meaningful or in fact it makes sense. So just take one example that okay suppose the nominal interest rate is 5%. And expected inflation is let's say 3%. And therefore the real interest rate is equal to 2%. Right? So if you make a loan you can earn 2% interest rate in real term that is the interest you earned in terms of real goods and service is you know like of 2%.

[00:19:45]Okay now suppose that the nominal interest rate rise to 8%. Okay.

[00:19:52]Initially it was 5%, but now it was you know like now it is like to 8% and also the inflation okay or the expected inflation also increased to now 10% over the course of a year. So now what is the real interest rate? The real interest rate is actually minus2%.

[00:20:16]Right? So even though the nominal interest rate is actually increased from 5% to 8%.

[00:20:24]Okay. Our real interest rate is actually opposite. Right. This is because in the in due course inflation also increase from 3% to 10%. And therefore understanding the inflation is very very important. Okay. it actually have a crucial role in you know like analyzing the bound investment or investment management. Okay. So in this case therefore you are 2% worship in real real term. Okay. So we cannot simply say that you know like an increase in nominal interest rate is actually you know like feel a person better off. No, right. It completely depends upon what is the inflation rate.

[00:21:14]Okay.

[00:21:18]Again, okay. So, if you are a lender in our case here, okay, what you would do?

[00:21:26]Okay. Just think yourself that if you are a lender, what what would you do?

[00:21:34]Right? So clearly you would be less eager to make a loan right you don't want to make a loan if you are a lender okay but but if you are a borrower then definitely you have already understood okay if you are a borrower then probably okay you would like to you know get more loan okay or you like to ask for more loan. So you are better off, right? Okay. So just remember that when the real interest rate is low, okay, when the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.

[00:22:26]Okay.

[00:22:28]Okay. So another important concept is in fact in finance basically is known as return. So what do you understand by return okay or how to compute return or what type of return actually we are talking about is it the same thing that we are you know like same thing that interest rate what we have learned. Okay. Is it the same as interest rate?

[00:23:00]The answer is not necessarily, right?

[00:23:03]The answer is not necessarily. Okay. The interest rate sometime can be act as return. Okay. But sometime the return is much more higher. Okay. Or lower than the stated interest rate. So interest rate is not necessarily the return. So what is return? Many people think that the interest rate on a bond tells them all they need to know about how well up they are as a result of owning it.

[00:23:34]Okay. So if the investor think he better off when he owns a long-term B yielding a 10% interest rate and the interest rate rise to 20% he will have a root a right. Okay. How if he has to sell the bond this he has to suffer a huge loss.

[00:23:58]Okay.

[00:24:01]Right. Therefore it is important that how well a person does by holding a bond or any other security over a particular time period is accurately measured by the return. Okay. or the rate of return.

[00:24:19]Okay. Right. So the rate of return in general can be computed as okay. RT which you know like basically we you know like major we know like we represent this return on the investment. Okay. Or RT A is equal to C + P. P P is the price.

[00:24:45]Okay. PT + 1 minus PT divided by PT.

[00:24:51]Okay. Where C is the coupon payment and P is the price. T + 1 is the tomorrow's price and P you know T is the today's price. So we can simply have it like C upon PT + PT + 1 minus PT / PT. Okay. Or simply we can take this component and this component. Okay. And therefore we can write like IC plus C. IC is the yield.

[00:25:26]Okay. Or the current plus the capital gain. Okay. Sometime okay if we are using this return for stock and if this C is actually D then this we can you know I call this as dividend yield. Now we could simply say like coupon yield or current yield. Okay, we can simply say current yield plus capital gain or capital loss. Okay, like G is representing here the capital gain.

[00:26:00]Right? So a 1,000 rupees face value bond with a coupon rate of 10% is bought for 1,000 rupees and held it for 1 year and then sold it for you know like let's say 1200 then what is the rate of return you are going to get okay the rate of return using this formula I will get is actually you know like 30% okay so now what you have to get it like the payment to the owner is the early coupon payment that is you know like 100 rupees and the change in the change in its value that is 200. So 100 + 200 divided by you know divided by the paging price initial paging price is in fact give you a 30% rate of return.

[00:27:03]Okay. So this is the you know like PT + 1 is you know PT + 1 here is our you know 1200 and PT is equal to you will take like this okay then the return can be computed as what we will compute as like this is 100 Okay. Plus this is 200. So it will be 300 divided by 1,000.

[00:27:44]Right? So you'll have here like 30% return.

[00:27:53]Okay. So let us now understand the changes in interest rate due to a change in expected inflation and the fer effect. how it is input. Okay. So the fer effect says that okay I is equal to R + expected inflation and therefore okay we understood it very very clearly here that the you know uh expected inflation will influence the interest rate for a given interest rate.

[00:28:31]Okay. And therefore for a given bond price when expected inflation increases the real cost of borrowing falls. Okay what we have already understood. Hence the quantity of bone supplied increased at any given bond prices. So an increase in expected inflation cause the supply of bone to increase and the supply curve to shift to right. Okay. A decrease in expected inflation caused the supply of bond to decrease and the supply curve to shift to left. What we have already seen. Okay. Now look at more carefully here that when the expected inflation rise. Okay. When the expected inflation rise, the supply curve shifts from the init. So this is the blue curve here is the initial you know like curve. This one. Okay. So this one is this initial supply curve and this one is the initial demand curve that is BD1 is the is our initial demand curve okay and B S1 is the initial supply curve and therefore.1 here okay like 0.1 here will actually give us the equilibrium price P1 and the equilibrium quantity. Okay. Now, so whenever expected inflation increases, the supply curve shifts from shifts from PS1 to B S2 that is towards the right.

[00:30:15]Okay. And the demand curve shifts from BD1 to BD 2 that is the left. So the demand curve shifts left and the supply curve shifts to right. So the equilibrium moves from.1 to now 2 causing the equilibrium bond price to fall from P1 to P2.

[00:30:42]Okay. And therefore the equilibrium interest rate rise. So whenever the equilibrium price decrease because we have already understood that there is an inverse relationship between price of the bond and interest rate. Whenever we understand P is decreasing that means interest rate I is increasing and therefore we have you know like understand that whenever inflation increase it will lead the I to increase.

[00:31:14]Okay, this is understood very well from the fer okay or we will call like sorry the fer equation okay the fer equation clearly give us the answer okay let us also understand the change in the interest rate due to business cycle expansion how does business cycle expansion actually influence the interest rate. What you have understood from the remember I am actually trying to explain you in the economics way of actually you know like looking at the interest rate. Okay. So in a business cycle expansion. So what do you understand by business cycle? Business cycle is basically the periodic fluctuation of economic activity. Okay.

[00:32:17]So periodic ups and downs of the economic activity is basically known as business cycle. Okay. So we have four phases in business cycle. And in the business cycle expansion is actually basically referring to the boom period.

[00:32:36]Okay. where everything is good, right?

[00:32:39]So total production increase high, you know, national income and consumer confidence is also high but inflation is also high at this period of time. So in a business cycle expansion, okay, when total production is very high which will lead the national income or the GDP to increase or you know like very high.

[00:33:04]Okay. So when in this situation or this environment firms willing to borrow more okay because they are likely to have a many profitable business or investment opportunities for which they need money okay and therefore they may go for you know the debt financing. Hence at a given bond price the supply of bond will increase. Okay.

[00:33:35]And this means that during a business cycle expansion, supply curve for bond shifts to right. Okay. So during the business cycle expansion, therefore supply curve for bond shifts to right.

[00:33:52]Okay.

[00:33:55]What happened to the demand side then?

[00:33:58]As the economy expands, okay, wealth is likely to increase.

[00:34:03]and the demand for bonds will also increase the demand curve will also shift to right. So in a business cycle expansion both demand curve for bond as well as the supply curve for bond shifts to right.

[00:34:23]Understood?

[00:34:25]Good. So now look at this diagram here that explain the changes in the interested due to business cycle expansion again. So our this is our original uh demand and supply curve for the bond. Okay. And the new curve okay this orange one is actually the new curve. Okay. So when a business cycle expansion, okay, so in a business cycle expansion when income and wealth are actually rising, the demand curve shifts rightward. Okay, what we have already seen the demand curve shifts rightward. Okay. From here to here. And also the supply curve also shifted to the right. Right from you know BS1 to BS2.

[00:35:27]Okay. But but it depend the the changes in price. Okay. Here. So you know the equilibrium now this is the initial equilibrium and now this is the in like new equilibrium and therefore there is a change in price from P1 to P2. Okay, this change is depend upon okay you know like which curve shifts okay what right so if supply shifts more than the demand okay if the supply curve of the bond shifts okay more than the demand curve then the price P decrease okay the price will decrease and therefore the equilibrium interest rate is likely to increase. Okay, which we have shown it in the diagram here.

[00:36:25]Right? So if the demand curve, okay, if the demand curve shifts more than the supply curve shifts, then the P is actually increase, right? So we will see it here like if the demand curve is you know like so if the demand curve is like here shifting towards right so it is sorry the demand curve is shifting towards right okay right so initially let's say it is shifting right and the supply curve is also shifting to right but we will Now this one is like right.

[00:37:11]So therefore we will have here like this is the C. Okay. So the corresponding price will be here. This is P3 and therefore price is actually increased.

[00:37:27]Okay. So price is increased in the sense that in the interest rate will fall.

[00:37:34]Okay.

[00:37:37]So in either case but in either case the quantity of bond sold is actually increase. So this is the initial quantity. So anything here okay whether it is from here or it is from here in any cases. Okay. Any of the case the quantity of bond sold is actually increase from here you know like this is you'll simply say like Q1 to Q2 to you know like Q3 it is engaged.

[00:38:15]Okay.

[00:38:18]Okay. So now you may be curious to know like know that why do interest rate falls during a recession. Okay let us understand this what will happen in the recession or when the economy enter into recession. Okay the consumer confidence actually will decline the business confidence will decline. Right?

[00:38:42]Okay. So at the beginning of an economic recession, household and farm expect that level of production and the employment will be lower than usual for some period of time. Right? So household will experience a declining in wealth and farm will also become more pessimistic about the future profitability of their investment projects. Okay. So the declining household wealth will lead to or the you know like it will cause the demand curve for the bond to shift to the left.

[00:39:21]Right? That's what we have already understood. Okay. So firm's declining expectation of the profitability of investment in physical capital to issue you know like very less bond. Okay. we shift the supply curve for the bond to the left.

[00:39:42]Okay. So the equilibrium bond price rise as long as the supply curve for bond shifts more than the demand curve. Okay.

[00:39:53]And therefore the equilibrium interest rate will decline.

[00:39:58]Okay. Let us now understand this using a diagram. Okay. In this okay in this you can clearly understand here that why do interest rate actually fall during the recession and remember what will happen. So this is one our initial demand curve you know like demand curve and the supply curve that is BD1 okay the demand for bond and vs1 is the supply for bond and initially we are here okay the price is P1 right so an economic downturn reduce the household wealth and decrease the demand for bond at any bond price okay so the bond on demand curve therefore shifts to left from D1 to D2. Right? So the recession caus the demand curve to shift to left.

[00:40:58]Okay? And also the fall in the expected profit okay or expected profit during the recession. Okay. So lenders it will actually you know like reduce the lender supply of bond at any bond price. Okay. And therefore the bond price also will shift to left. So both the demand curve shifting to left and also the supply curve is shifting to left. in the case of recession. Okay, just the opposite in the case of you know like business expansion.

[00:41:44]Okay, so here as long as the supply of bond curve is large and the shifting of the supply of bond curve is higher than the shifting of the demand curve. Okay, the price is actually in right. So in the new equilibrium therefore which is at two you know like a two here the bond price rise from P1 to P2.

[00:42:17]Okay here in this case right so this is our sorry this is our P2 and here corresponding to this equilibrium point here. So P P1 okay is here and P2 is here and there is a changes in price which is increasing that implies that interest rate is actually decreasing. So what we have understood here is like so in the economic expansion okay or the business expansion right both the demand for bond curve and the supply of bond curve will shift to right but in the economic recession both the demand for bond and the supply of bond will shift to left. This will in fact cause the price to increase as long as the supply of bond is or the shift in supply of bond is higher than the shift in quantity or sorry shift in the demand for bond and therefore this implies that interest rate will declining during the okay so now that I believe you have understood the relationship between interest rate and inflation and how interest rate behave in a typical situation when in case of business expansion and in case of economic recession. Okay. The other way of thinking the relationship between interest rate and you know inflation is that whenever inflation is very very high or whenever inflation is high.

[00:44:08]Okay. Now the central bank actually want to control this inflation because one of the objective of central bank is to control for inflation that is price stability. Okay. So when the central bank or when the government see that inflation is really high it will actually control the inflation by increasing the interest rate. So usually they will set a you know like higher rate of interest. So both the fer effects as well as this activity of central bank will enable us to understand that whenever inflation is high okay the interest rate also is going to high. So an increase in in inflation will lead to increase in interest rate which is actually major concern about the or major concern for the bond investors.

[00:45:11]Okay. So in the next session we are going to discuss the yield curve and the concepts related to the yield curve and therefore we will also discuss some of the economic theory that explain such el curves. Okay for now we will stop here.