I am trying to understand the relationship between security prices and interest rates. According to Schweser, when there is an excess supply of money due to high interest rates, households try to reduce the opportunity cost of holding money by buying securities. This drives down interest rates and raises security prices, restoring equilibrium interest rates/quantity of money.
However, I do not understand why the increased demand for securities should bid down interest rates. Is it because money lenders have to “compete with securities” by lowering its cost of borrowing? Conversely, when there is excess money demand due to low rates and households try to dump securities in exchange for cash, why do interest rates increase as securities prices fall?
Should I, instead, think of “money lenders” and “securities” as the same thing> Would it make sense just to think of a simple supply (of securities) and demand (for money) graph and look at the effects of supply/demand on prices, then take the results to the money supply/money demand graph?
Thank you in advance.
Simply put, when there is excess money in an economy, people have more money than they are willing to spend. So they will start buying securities (bonds). As they buy more and more bonds, their price increase which results in a decrease in interest rate (recall the inverse relationship between bond price and interest rates). Interest rate will decrease until the demand for money equals the supply of money. If there is excess demand for money, it means that there isn’t enough money in the economy to satisfy people’s needs. They will start selling bonds to get cash which will reduce bond prices and consequently increase their yields. This will restore equilibrium in the money market. Think about it in terms of bond prices, what happens if people sell more and more bonds? The price will decrease because you end up having an excess supply of bonds in the market. Since bond price are inversely related to interest rates, interest rates must go up. Same thing happens if people start buying more and more bonds but in reverse order. This approach pretty much sums up what you said in your last paragraph.
Thank you for your great explanation–it makes complete sense now knowing that securities denote bonds. However, while I have internalized the inverse relationship between bond prices and interest rates (i.e. I can see how a government purchase of bonds to increase monetary supply would reduce the supply of bonds, drive up bond prices, and in turn lower interest rates to restore equilibrium in the money market), I have always thought that interest rates were the main drivers of bond prices. Most of the explanations on the relationship between bond prices and interest rates start with interest rates as a “causal” factor, and do not explain how a direct increase in bond prices would lower interest rates, etc. Is there an intuitive explanation for “both directions” of the inverse relationship?
I look at if from a simple demand supply of funds perspective. If people invest more, more funds are available to lend in the economy and this reduces the interest rate (supply of fund exceeds demand for funds so price (interest rates) need to go down). If people withdraw funds, less funds are available to lend in the economy so the interest rate must go up (demand of funds exceed supply of fund so price (interest rates) goes up). Interest rates in an economy can be thought as being the cost of money or the cost of holding cash relative to investments.