Supply and Demand in the Bond Market

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Supply and Demand in the Bond Market
Law of Demand

It stats that “The higher the price of bond lower the demanded of bond”. The demand curve illustrates the negative or inverse relation between price and quantity of demand bond and direct between interest and quantity of demand bond.

Law of Supply

It stats that “The higher the price of bond the higher the quantity of supply bond”. The supply curve illustrates the positive or direct relation between price and quantity of supply bond and inverse between interest and quantity of supply bond.



Change in Equilibrium interest rates

It is important to make the distinction between movements along a demand (or supply) curve and shifts in a demand (or supply) curve.

i. Movement along the Demand (or Supply) Curve

When quantity demand (or supply) changes as a result of change in the price of the bond (a change in interest), we have a movement along the demand or supply curve

ii. Shift in Demand (or Supply) Curve

A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded (or supply) changes at each given price (or interest rate) of the bond in response to a change in some other factor besides the bond’s price or interest rate. When one of these factors changes, causing a shift in the demand or supply curve, there will be a new equilibrium value for the interest rate.

Factors that Shift the Demand curve
Variable
Change in variable
Change in Quantity Demanded
P & i
Wealth
Increase
Increase
Both Increase
Expected interest rate
Increase
Decrease
Both Increase
Expected inflation
Increase
Decrease
Both Increase
Riskiness of bonds
Increase
Decrease
Both Increase
Liquidity
Increase
Increase
Both Increase

Factors that Shift the Supply Curve

Variable
Change in variable
Change in Quantity Demanded
P & i
Profitability of investments
Increase
Increase
Both Increase
Expected inflation
Increase
Increase
Both Increase
Government Deficit
Increase
Increase
Both Increase

Effect of Expected Inflation

We have already done most of the work to evaluate how a change in expected inflation affects the nominal interest rate, in that we have already analyzed how change in expected inflation shifts the supply and demand curves. Figure shows that effect on the equilibrium interest rate if an increase in expected inflation. 

When the demand and supply curves moves from point 1 to point 2, the intersection of Bd2 and Bs2. The equilibrium bond price has fallen from P1 to P2 and because the bond price is negatively related to interest rate, this means that the interest rate has risen from i1 to i2.

Effect of Business Cycle

In a business cycle expansion, the amounts of goods and services being produced in the economy rise , so national income increases. When this occurs, businesses will be more willing to borrow, because they are likely to have many profitable investment opportunities for which they need financing. Hence at a given bond price and interest rate, the quantity of bonds that firms want to sell will increase. This means that in business cycle expansion, the supply curve for bonds shifts to the right from Bs1 to Bs2.
Expansion in the economy will also affect the demand for bonds. As the business cycle expands, wealth is likely to increase, and then the theory of asset demand tells us that the demand for bonds will rise as well. We see this in figure, where the demand curve has shifted to the right from Bd1 to Bd2.
As you can see, the interest rate rises during business cycle expansions and falls during recessions, which is what the supply and demand diagram indicates.


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