Minicase 3: Analyzing Interest Rates and Market Equilibrium Solution

This case study solution provides a comprehensive analysis of interest rate behavior and the models used to predict future rates. It addresses key concepts such as the Fisher effect, loanable funds framework, and liquidity preference framework. The solution includes computations for expected bond returns under different market prices and discusses factors that shift the demand and supply curves for bonds, including changes in wealth, inflation rates, expected interest rates, risk, and liquidity. It also explains the relationship between real interest rates and expected inflation, and how interest rates are determined by the equilibrium between the demand and supply of loanable funds, as well as the preference of investors towards liquidity. The document also includes a discussion of how changes in income levels and inflation impact interest rates.

MONEY AND BANKING
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Question 1
The expected return on the bond for the given cases is computed as shown below.
Question 2
The requisite computation is as shown below.
Question 3
The factors that are responsible for shift in the demand curve of bonds are as follows
(Damodaran, 127-129)
 Wealth change leading to changes in availability of capital for investment
 Inflation rate decrease leading to increase in the bond price and hence resulting in
higher demand
 Expected interest rate decline leading to increase in the bond price thus increasing
demand
 Changing risk associated with bonds
 Changing liquidity of bond thus altering the liquidity premium associated with the
bond

Question 4
The factors that are responsible for shift in the supply curve of bonds are as follows (Arnold,
187-189)
 Alterations in the inflation rate since it would determine the market interest rate which
in-turn would decide the market price of bonds.
 There is an increase in the interest rate leading to higher rate of market rate which in
turn would lower the value of bonds and hence increase the supply.
 If there is increase in the associated risk, then the market interest rate would rise
leading to a crash in prices and hence increasing the supply.
 If there is change in liquidity, then the supply of bonds would also be altered
Question 5
Fischer effect refers to the assumption that over a period of time, the real interest rates and
the expected inflation rate tend to move in tandem. When there is an increase in the inflation
rate, then the bond demand would become less which would lead to investments being shifted
to other asset classes rather than bonds. However, if the supply remains constant, then
gradually the interest rates applicable on bonds would also show a downward trend (Arnold,
223-224).
Question 6
In accordance with the loanable funds framework, the interest rate depends on the
equilibrium attained between the demand and supply of loanable funds. At a given interest
rate, there would be certain demand of loanable funds which would decrease as the interest
rate increases. On the other hand, the supply of loanable funds would be an upward sloping
curve since supply at higher interest rates would be higher. The interest rate at which the
demand and supply match would be applicable interest. In the event of higher income levels,
the demand for loans would increase leading to higher interest rates. Further, in case of
higher inflation, the interest rates would also increase (Damodaran, 201-202)
As per the liquidity preference framework, interest is not paid for the saving but rather for the
underlying liquidity associated with money. This liquidity is essentially represented by the
demand of money. Consider that there are two asset classes i.e. money and bond. The

demand for money would be downward sloping since when there is a lower interest rate, the
bond demand also remains tepid and hence people would like to keep their money in the form
of cash so as to conserve liquidity. The interest rate is essentially determined by the
intersection of demand and supply of money which would essentially indicate the preference
of investors towards liquidity. The demand for money would increase in case of higher
inflation, higher income levels and hence would lead to higher interest rates (Arnold, 225-
227).
Question 7
The relevant changes are highlighted as follows.

References
Arnold, Glen, Corporate Financial Management., Sydney: Financial Times Management. 2015
Damodaran, Aswath, Applied corporate finance: A user’s manual New York:Wiley, John &
Sons, 2015