the Bond Market and interest rates A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make periodic payments for a specified period of time.1 The bond market is especially important to economic activity because it enables corporations and governments to borrow money to finance their activities, and because it is where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). Many types of interest rates are found in the economy—mortgage interest rates, car loan rates, and interest rates on many different types of bonds.
Interest rates are important on a number of levels. On a personal level, high interest rates might deter you from buying a house or a car because the cost of financing would be high. Conversely, high interest rates might encourage you to save because you can earn more interest income by putting aside some of your earnings as savings. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save, but also businesses’ investment decisions. High interest rates, for example, might cause a corporation to postpone building a new plant that would provide more jobs.
Because changes in interest rates affect individuals, financial institutions, businesses, and the overall economy, it is important to explain substantial fluctuations in interest rates over the past 35 years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate fell to 3% in late 1992 and 1993, rose to above 5% in the mid-to-late 1990s, fell to below 1% in 2004, rose to 5% by 2007, and fell to close to zero from 2008 to 2014.
Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to “the” interest rate. As Figure 1 shows, however, interest rates on several types of bonds can differ substantially. The interest rate on three-month Treasury bills, for example, fluctuates more than the other interest rates, and is lower on average. The interest rate on Baa (medium-quality) corporate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became larger in the 1970s, narrowed in the 1990s, rose briefly in the early 2000s, narrowed again, and then rose sharply starting in the summer of 2007. It then began to decline toward the end of 2009, returning to low levels by 2014.
In Chapter 2 we study the role of bond markets in the economy, and in Chapters 4 through 6 we examine what an interest rate is, how the common movements in interest rates come about, and why the interest rates on different bonds vary.