Search Results

The issuer of a bond is borrowing money from the holder of the bond and promises to pay back the loan according to a predefined payment scheme. An individual who has a clear preference for current capital to finance investments or current consumption can borrow by issuing a bond to an individual who has a clear preference for future consumption opportunities. The price of a bond of a given maturity is, of course, set to align the demand and supply of that bond, and will consequently depend on the attractiveness of the real investment opportunities and on the individuals' preferences for consumption over the maturity of the bond. The term ‘structure of interest rates’ will reflect these dependencies. This chapter derives relations between equilibrium interest rates and aggregate consumption and production in settings with a representative agent. Examples of equilibrium term structure models that are derived from the basic relations between interest rates, consumption, and production are given. The relation between real and nominal yields is discussed. Finally, some traditional hypotheses about the shape of the term structure are critically reviewed.

This chapter focuses on the consequences of general asset pricing theory for the pricing of bonds and for the term structure of interest rates implied by bond prices. After a short introduction to the notation and the bond market terminology, relations are derived between equilibrium interest rates and aggregate consumption and production in settings with a representative individual. The famous Vasicek and Cox-Ingersoll-Ross models are shown to follow as special cases. The implications of these models for the term structure of interest rates are explored. The relation between real and nominal interest rates and yield curves is investigated, both in a general setting and in specific models. Finally, the traditional expectation hypothesis is critically reviewed.

This chapter presents a simple continuous-time model with microeconomic foundations and uses it to analyze some of the questions related to the fiscal theory of the price level (FTPL) and to a policy of pegging the nominal interest rate. The chapter is organized as follows. Section 1 presents the model and elaborates on some basic points to be addressed. Section 2 considers the case of a “monetary rule,” in which the government sets the path of the money supply, and Section 3 compares the model’s conclusions to some of the propositions in the literature. Section 4 discusses the case of a central bank pegging the nominal interest rate, and Section 5 concludes. It is shown that the hyperinflationary solution as an alternative rational expectations path does not exist (in the context of an exogenous monetary rule) for the general case of a positive rate of monetary expansion. Indeed, there is no reason for the usual statement that such a path is the FTPL alternative to the monetary explanation resulting in a steady-state, noninflationary path of prices and real variables.

Until recently, it was widely believed that central banks must protect people from their own worst instincts: the populace demands easy money and low interest rates, and a politically sensitive representative class will give it to them. Central banks have the responsibility of resolving this time inconsistency problem by protecting the long-term value of the currency even against the short term demands of politics. Yet the financial crisis of 2008 and the 2016 election have changed this narrative. This chapter explores how this new political economy of central banking, in the face of long-term low interest rates, changes the posture of central banks against the rest of the polity. It discusses some history of political pressures against central banks in other climates and makes predictions about how the ‘new normal’ of lower interest rates will challenge the Fed’s ability to stay above the political fray, despite its best intentions.

Chapter 2 sets out the basic framework. It considers an economy evolving indefinitely in discrete time, with producers, consumers, and a central bank as principal actors. Individuals plan over finite horizons and form expectations according to what they see. Money is conceived of as a commodity that is produced through credit creation rather than distributed by a fancy helicopter. This natural way to represent money is rarely followed in the literature and differs sharply from the usual helicopter drops because it ties money creation to credit creation. The chapter’s upshot is a system of simultaneous equations determining prices, wages, and the nominal interest rate. Using this solution, individuals revise their expectations, and the economy proceeds to the next period. The chapter concludes with functional and numerical specifications for later simulations, the purpose of which is to analyze key economic processes and to derive meaningful results.