Shifts in the supply of bonds

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Certain factors can cause the supply curve for bonds to shift, among them these:
1. Expected profitability of investment opportunities
2. Expected inflation
3. Government budget

We will look at how the supply curve shifts when each of these factors changes (all others remaining constant). (As a study aid, Table 4.3 summarizes the effects of changes in these factors on the bond supply curve.)

Expected Profitability of Investment Opportunities The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profitable abound, and the quantity of bonds supplied at any given bond price will increase (see Figure 4.3). Therefore, in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. Likewise, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shifts to the left

 The real cost of borrowing is more  accurately measured by the real interest rate, which equals the (nominal) interestrate minus the expected inflation rate. For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence the quantity of bonds supplied increases at any given bond price. An increase in expected

inflation causes the supply of bonds to increase and the supply curve to shift to the right (see Figure 4.3).

Government Budget The activities of the government can influence the supply of bonds in several ways. The U.S. Treasury issues bonds to finance government deficits, the gap between the government’s expenditures and its revenues. When these deficits are large, the Treasury sells more bonds, and the quantity of bonds supplied at each bond price increases. Higher government deficits increase the supply of bonds and shift the supply curve to the right (see Figure 4.3). On the other hand, government surpluses, as occurred in the late 1990s, decrease the  supply of bonds and shift the supply curve to the left.

State and local governments and other government agencies also issue bonds to finance their expenditures, and this can also affect the supply of bonds. We now can use our knowledge of how supply and demand curves shift to analyze how the equilibrium interest rate can change. The best way to do this is to pursue several case applications. In going through these applications, keep two things in mind:

1. When you examine the effect of a variable change, remember that we are assuming that all other variables are unchanged; that is, we are making use  of the ceteris paribus assumption.
2.  Remember that the interest rate is negatively related to the bond price, so when the equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.

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