Things to remember:
The price of bonds and the interest rate are negatively related.
When expected in inflation rises, the supply and demand curve
move in such a way that causes the price of bonds to decrease,
causing an increase in the interest rate.
So when expected inflation rises, the interest rate will rise.
Japan and low interest rates:
In 1998, interest rates on Japanese 6 month treasury bills turned
During this time, Japan experience a prolonged recession, which was
accompanied by deflation, a negative inflation rate. Negative inflation
caused the demand for bonds to rise because the expected return on
real assets fell, thereby raising the relative expected return on bonds
and in turn causing the demand curve to shift to the right. The
negative inflation rate also raised the real interest rate and therefore
the real cost of borrowing for any given nominal rate, thereby causing
the supply of bonds to contract and the supply curve to shift to the left.
These changes led to a rise in the bond price and a fall in interest
One attribute of a bond that influences its interest rate is its risk of
which occurs then the issuer of the bond is unable or unwilling to make
interest payments when promise or to pay the face value when the bond
Treasury bills are considered
The spread between the interest rates on bonds with default risk and default-
free bonds, both of the some maturity, called the
how much additional interest people must earn to be wiling to hold that risky
also take into account liquidity. The less liquid an
asset is, the higher its risk premium.
A bond with default risk always has a positive risk premium.
The higher the default risk, the larger the risk premium will be.