Money and Banking Lecture 15

Review of the Previous Lecture Bonds Yield to Maturity Current Yield Holding Period Returns Bond Supply, Demand and Equilibrium

Topics under Discussion Factors Influencing Bond Supply Factors Influencing Bond Demand Bond and Risk Default Risk Inflation Risk Interest Rate Risk

Factors that shift Bond Supply Changes in government borrowing Any increase in the government’s borrowing needs increases the quantity of bonds outstanding, shifting the bond supply curve to the right. This reduces price and increases the interest rate on the bond.

Factors that shift Bond Supply Changes in business conditions business-cycle expansions mean more investment opportunities, prompting firms to increase their borrowing and increasing the supply of bonds As business conditions improve, the bond supply curve shifts to the right. This reduces price and increases the interest rate on the bond. By the same logic, weak economic growth can lead to rising bond prices and lower interest rates

Factors that shift Bond Supply Changes in expected inflation Bond issuers care about the real cost of borrowing, So if inflation is expected to increase then the real cost falls and the desire to borrow rises, resulting in the bond supply curve shifting to the right This reduces price and increases the interest rate on the bond.

Factors that shift Bond Supply

Factors that shift Bond Supply

Factors that shift Bond Demand wealth An increases in wealth shift the demand for bonds to the right as wealthier people invest more. This will happen as the economy grows during an expansion. This will increase Bond Prices and lower yields.

Factors that shift Bond Demand Expected inflation A fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering the yield and increasing the Bond’s price.

Factors that shift Bond Demand Expected return on stocks and other assets If the return on bonds rises relative to the return on alternative investments, the demand for bonds will rise. This will increase bond prices and lower yields.

Factors that shift Bond Demand Risk relative to alternatives If a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right.

Factors that shift Bond Demand Liquidity of bonds relative to alternatives When a bond becomes more liquid relative to alternatives, the demand curve shifts to the right.

Factors that shift Bond Demand

Factors that shift Bond Demand

Equilibrium An increase in expected inflation shifts bond supply to the right and bond demand to the left. The two effects reinforce each other, resulting in a lower bond price and a higher interest rate

Equilibrium

Equilibrium A business-cycle downturn shifts the bond supply to the left and the bond demand to the left. In this case the bond price can rise or fall, depending on which shift is greater. But interest rates tend to fall in recessions, so bond prices are likely to increase

Equilibrium

Bonds and Risk Sources of Bond Risk Default Risk Inflation Risk Interest-Rate Risk

Summary Factors Influencing Bond Supply Factors Influencing Bond Demand Equilibrium Conditions