ECON
Class 6

# This means that as the price of a bond increases the

• Notes
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governments are willing to borrow more by issuing bonds. This means that as the price of a bond increases, the quantity supplied of that bond will increase. Equilibrium in the Bond Market As you might expect, equilibrium in the bond market occurs at the intersection of the supply and demand curves. At this price and interest rate, the quantity of bonds that borrowers want to issue (supply) is just equal to the quantity that lenders want to purchase (demand). Market equilibrium means there is no shortage or surplus of bonds in the market. Graphically, Figure 6-4 Equilibrium in the bond market P B s i 600 0 400 50 200 B d 200 100 200 300 Q In this example, equilibrium occurs at a price of \$400, interest rate of 50%, and at a quantity of 200 bonds. (Please verify that this is the equilibrium from the equations provided.) At a price above \$400 there would be a surplus of bonds, and at a price below \$400 there would be a shortage of bonds. Only at a price of \$400 does the quantity 48

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 supplied equal the quantity demanded. (Of course, these interest rates are unlikely in the United States, but they make the math easier.) Changes in Bond Demand and Bond Supply Increase in demand An increase in demand leads to an increase in the price and quantity of the bond, and a decrease in the interest rate: Figure 6-5 An increase in demand P B d B s i 600 0 400 50 200 B d 200 100 200 300 Q The price increases from 400 to 600 and the quantity increases from 200 to 300. Factors that may cause an increase in demand include an increase in wealth, liquidity, or expected return relative to other assets, or a decrease in the risk of an asset relative to other assets. An increase in supply An increase in supply leads to an increase in the quantity of the bond exchanged and a decrease in the price of the bond or an increase in interest rates. Figure 6-6 An increase in supply P B s i 600 0 400 B s 50 200 B d 200 100 200 300 Q The price decreases from \$400 to \$200, while the quantity increases from 200 to 300. An increase in the supply of a bond can be caused by an increase in expected profitability of 49
Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 investment opportunities, an increase in expected inflation, or an increase in government deficits. Note that one important result is that an increase in the government budget deficit, as Bush and Obama have done, will lead to higher interest rates. The Market for Loanable Funds An alternative, but closely related, model of interest rates is the loanable funds market. The loanable funds market: is the market where those with surplus funds are able to lend to those with more productive uses of funds. Those who want them obtain funds by issuing bonds, while those who have them are able to put excess funds to more productive use by purchasing bonds. So the bond market and loanable funds market are closely related: they are the converse of each other. The demand for loanable funds: is equivalent to the supply of bonds. Borrowers demand funds by supplying bonds. An increase in the demand for loanable funds is the same as an increase in the supply of bonds.

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