Market Interest Rates and the Demand and Supply for Bonds
We can use the determinants of portfolio choice just discussed to show how the interaction of the demand and supply for bonds determines market interest rates. Although demand and supply analysis should be familiar from your introductory economics course, applying this analysis to the bond market involves a difficulty. Typically, we draw demand and supply graphs with the price of the good or service on the vertical axis. Although we are interested in the prices of bonds, we are also interested in their interest rates. Fortunately, as we learned in Chapter 3, the price of a bond, P, and its yield to maturity, i, are linked by the arithmetic of the equation showing the price of a bond with coupon payments C that has a face value FV and that matures in n years
We can use the determinants of portfolio choice just discussed to show how the interaction of the demand and supply for bonds determines market interest rates. Although demand and supply analysis should be familiar from your introductory economics course, applying this analysis to the bond market involves a difficulty. Typically, we draw demand and supply graphs with the price of the good or service on the vertical axis. Although we are interested in the prices of bonds, we are also interested in their interest rates. Fortunately, as we learned in Chapter 3, the price of a bond, P, and its yield to maturity, i, are linked by the arithmetic of the equation showing the price of a bond with coupon payments C that has a face value FV and that matures in n years
Because the coupon payment and the face value do not change, once we have determined the equilibrium price in the bond market, we have also determined the equilibrium interest rate.With this approach to showing how market interest rates are determined, sometimes called the bond market approach, we are considering the bond as the “good” being traded in the market. The bond market approach is most useful when considering how the factors affecting the demand and supply for bonds affect the interest rate. An alternative approach, called the market for loanable funds approach, treats the funds being traded as the good. The loanable funds approach is most useful when considering how changes in the demand and supply of funds affect the interest rate. As we will see in section 4.4, we can use the loanable funds approach to analyze connections between U.S. and foreign financial markets. The two approaches are, in fact, equivalent.As in other areas of economics, which model we use depends on which aspects of a problem are most important in a particular situation.
A Demand and Supply Graph of the Bond Market
Figure 4.1 illustrates the market for bonds. For simplicity, let’s assume that this is the market for a one-year discount bond that has a face value of $1,000 at maturity. The figure shows that the equilibrium price for this bond is $960, and the equilibrium
A Demand and Supply Graph of the Bond Market
Figure 4.1 illustrates the market for bonds. For simplicity, let’s assume that this is the market for a one-year discount bond that has a face value of $1,000 at maturity. The figure shows that the equilibrium price for this bond is $960, and the equilibrium
quantity of bonds is $500 billion.We can calculate the interest rate on the bond using the formula from Chapter 3 for a one-year discount bond that sells for price P with face value FV:
As with markets for goods and services, we draw the demand and supply curves for bonds holding constant all factors that can affect demand and supply, other than the price of bonds. The demand curve for bonds represents the relationship between the price of bonds and the quantity of bonds demanded by investors, holding constant all other factors. As the price of bonds increases, the interest rates on the bonds will fall, and the bonds will become less desirable to investors, so the quantity demanded will decline. Therefore, the demand curve for bonds is downward sloping, as shown in Figure 4.1. Next, think about the supply curve for bonds. The supply curve represents the relationship between the price of bonds and the quantity of bonds supplied by investors who own existing bonds and by firms that are considering issuing new bonds. As the price of bonds increases, their interest rates will fall, and holders of existing bonds will be more willing to sell them. Some firms will also find it less expensive to finance projects by borrowing at the lower interest rate and will issue new bonds. For both of these reasons, the quantity of bonds supplied will increase.
As with markets for goods and services, if the bond market is currently in equilibrium, it will stay there, and if it is not in equilibrium, it will move to equilibrium. For example, in Figure 4.2, suppose that the price of bonds is currently $980, which is above the equilibrium price of $960. At this higher price, the quantity demanded is $400 billion (point B),which is less than the equilibrium quantity demanded,while the quantity supplied is $600 billion (point C), which is greater than the equilibrium quantity supplied. The result is that there is an excess supply of bonds equal to $200 billion. Investors are buying all the bonds they want at the current price, but some sellers cannot find buyers. These sellers have an incentive to reduce the price they are willing
As with markets for goods and services, if the bond market is currently in equilibrium, it will stay there, and if it is not in equilibrium, it will move to equilibrium. For example, in Figure 4.2, suppose that the price of bonds is currently $980, which is above the equilibrium price of $960. At this higher price, the quantity demanded is $400 billion (point B),which is less than the equilibrium quantity demanded,while the quantity supplied is $600 billion (point C), which is greater than the equilibrium quantity supplied. The result is that there is an excess supply of bonds equal to $200 billion. Investors are buying all the bonds they want at the current price, but some sellers cannot find buyers. These sellers have an incentive to reduce the price they are willing
to accept for bonds so that investors will buy their bonds. This downward pressure on bond prices will continue until the price has fallen to the equilibrium price of $960 (point E). Now suppose that the price of bonds is $950, which is below the equilibrium price of $960. At this lower price, the quantity demanded is $550 billion (point A), which is greater than the equilibrium quantity demanded, while the quantity supplied is $450 billion (point D), which is less than the equilibrium quantity supplied. The result is that there is an excess demand for bonds equal to $100 billion. Investors and firms can sell all the bonds they want at the current price, but some buyers cannot find sellers. These buyers have an incentive to increase the price at which they are willing to buy bonds so that firms and other investors will be willing to sell bonds to them. This upward pressure on bond prices will continue until the price has risen to the equilibrium price of $960.
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