Explaining Changes in Equilibrium Interest Rates
In drawing the demand and supply curves for bonds in Figure 4.1, we held constant everything that could affect the willingness of investors to buy bonds—or firms and investors to sell bonds—except for the price of bonds. You may remember from your introductory economics course the distinction between a change in the quantity demanded (or the quantity supplied) and a change in demand (or supply). If the price of bonds changes, we move along the demand (or supply) curve, but the curve does not shift, so we have a change in quantity demanded (or supplied). If any other relevant variable—such as wealth or the expected rate of inflation—changes, then the demand (or supply) curve shifts, and we have a change in demand (or supply). In the next sections, we review the most important factors that cause the demand curve or the supplycurve for bonds to shift.
In drawing the demand and supply curves for bonds in Figure 4.1, we held constant everything that could affect the willingness of investors to buy bonds—or firms and investors to sell bonds—except for the price of bonds. You may remember from your introductory economics course the distinction between a change in the quantity demanded (or the quantity supplied) and a change in demand (or supply). If the price of bonds changes, we move along the demand (or supply) curve, but the curve does not shift, so we have a change in quantity demanded (or supplied). If any other relevant variable—such as wealth or the expected rate of inflation—changes, then the demand (or supply) curve shifts, and we have a change in demand (or supply). In the next sections, we review the most important factors that cause the demand curve or the supplycurve for bonds to shift.
Factors That Shift the Demand Curve for Bonds
In section 4.1, we discussed the factors that determine which assets investors include in their portfolios. A change in any of these five factors will cause the demand curve for bonds to shift:
In section 4.1, we discussed the factors that determine which assets investors include in their portfolios. A change in any of these five factors will cause the demand curve for bonds to shift:
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| Figure 4.1 |
1. Wealth
2. Expected return on bonds
3. Risk
4. Liquidity
5. Information costs
Wealth When the economy is growing, households will accumulate more wealth. The wealthier savers are, the larger the stock of savings they have available to invest in financial assets, including bonds. Therefore, as Figure 4.3 shows, an increase in wealth, holding all other factors constant, will shift the demand curve for bonds to the right from D1 to D2 as savers are willing and able to buy more bonds at any given price. In the figure, as the demand curve for bonds shifts to the right, the equilibrium price of bonds rises from $960 to $980, and the equilibrium quantity of bonds increases from 500 billion to $600 billion. So, equilibrium in the bond market moves from point E1 to point E2. During a recession, as occurred during 2007–2009, households will experience declining wealth, and, holding all other factors constant, the demand curve for bonds will shift to the left, reducing both the equilibrium price and equilibrium quantity. In Figure 4.3, as the demand curve for bonds shifts to the left from D1 to D3, the equilibrium price falls from $960 to $940, and the equilibrium quantity of bonds decreases from $500 billion to $400 billion. So, equilibrium in the bond market moves from point E1 to point E3.
2. Expected return on bonds
3. Risk
4. Liquidity
5. Information costs
Wealth When the economy is growing, households will accumulate more wealth. The wealthier savers are, the larger the stock of savings they have available to invest in financial assets, including bonds. Therefore, as Figure 4.3 shows, an increase in wealth, holding all other factors constant, will shift the demand curve for bonds to the right from D1 to D2 as savers are willing and able to buy more bonds at any given price. In the figure, as the demand curve for bonds shifts to the right, the equilibrium price of bonds rises from $960 to $980, and the equilibrium quantity of bonds increases from 500 billion to $600 billion. So, equilibrium in the bond market moves from point E1 to point E2. During a recession, as occurred during 2007–2009, households will experience declining wealth, and, holding all other factors constant, the demand curve for bonds will shift to the left, reducing both the equilibrium price and equilibrium quantity. In Figure 4.3, as the demand curve for bonds shifts to the left from D1 to D3, the equilibrium price falls from $960 to $940, and the equilibrium quantity of bonds decreases from $500 billion to $400 billion. So, equilibrium in the bond market moves from point E1 to point E3.
Expected Return on Bonds If the expected return on bonds rises relative to expected returns on other assets, investors will increase their demand for bonds, and the demand curve for bonds will shift to the right. If the expected return on bonds falls relative to expected returns on other assets, the demand curve for bonds will shift to the left.Note that it is the expected return on bonds relative to the expected returns on other assets that causes the demand curve for bonds to shift. For instance, if the expected return on bonds remained unchanged, while investors decided that the return from investing in stocks would be higher than they had previously expected, the relative return on bonds would fall, and the demand curve for bonds would shift to the left.
The expected return on bonds is affected by the expected inflation rate.We saw in Similarly, the expected real return on bonds equals the nominal return minus the expected inflation rate. An increase in the expected inflation rate reduces the expected real return on bonds, which will reduce the willingness of investors to buy bonds and shift the demand curve for bonds to the left. A decrease in the expected inflation rate will increase the expected real return on bonds, increasing the willingness of investors to buy bonds and shift the demand curve for bonds to the right
Risk An increase in the riskiness of bonds relative to the riskiness of other assets decreases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the left. A decrease in the riskiness of bonds relative to the riskiness of other assets increases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the right. It is the perceived riskiness of bonds relative to other assets that matters. If the riskiness of bonds remains unchanged but investors decide that stocks are riskier than they had previously believed, the relative riskiness of bonds will decline, investors will increase their demand for bonds, and the demand curve for bonds will shift to the right. In fact, during late 2008 and early 2009, many investors believed that the riskiness of investing in stocks had increased. As a result, investors increased their demand for bonds, which drove up the equilibrium price of bonds and, therefore, drove down the equilibrium interest rate on bonds. The quantity of corporate bonds issued in the United States in 2009 soared to $2.84 trillion, which was 38% more than in 2008
Liquidity Investors value liquidity in an asset because an asset with greater liquidity can be sold more quickly and at a lower cost if the investor needs the funds to, say, buy a car or invest in another asset. If the liquidity of bonds increases, investors demand more bonds at any given price, and the demand curve for bonds shifts to the right. A decrease in the liquidity of bonds shifts the demand curve for bonds to the left. Once again, though, it is the relative liquidity of bonds that matters. For instance, online trading sites first appeared during the 1990s. These sites allowed investors to buy and sell stocks at a very low cost, so the liquidity of many stocks increased. The result was that the relative liquidity of bonds decreased, and the demand curve for bonds shifted to the left
Information Costs The information costs investors must pay to evaluate assets affect their willingness to buy those assets. For instance, beginning in the 1990s, financial information began to be easily available on the Internet either for free or for a low price. Previously, an investor could find this information only by paying for a subscription to a newsletter or by spending hours in libraries, gathering data from annual reports and other records. Although the Internet helped to lower the information costs for both stocks and bonds, the effect appears to have been greater for bonds. Because stocks had been more widely discussed in the Wall Street Journal and other newspapers and magazines, while bonds had been less discussed, the impact of the Internet on the information available on bonds was greater. As a result of the lower information costs, the demand curve for bonds shifted to the right. During the financial crisis, many investors came to believe that for certain types of bonds—particularly mortgagebacked securities—they lacked sufficient information to gauge the likelihood that the bonds might default. Gathering sufficient information appeared to be very costly, if it were possible at all. As a result of these higher information costs, the demand curve for bonds shifted to the left.
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