Question

From the Portfolio Choice Theory: Consider an economy which is undergoing a recession. Using and drawing the demand and supply of bonds, show and explain what happens.

Answer 1

In each graph, D0 & S0 are initial demand and supply curves of bonds, intersecting at point A with initial bond price P0 and quantity of bonds Q0.

During a recession, investors incomes decrease, so demand for bonds decreases. The bond demand curve shifts leftward, decreasing price and decreasing quantity of bonds. At the same time, firms don't undertake any expansio activities during recession, so they decrease business investment and therefore issue less bonds, so bond supply decreases. The bond supply curve shifts leftward, increasing price and decreasing quantity.

The net effect is a definite decrease in quantity. But price may increase, decrease or stay the same, depending on the relative shifts in the curves. 3 situations arise:

(1) Leftward shift in demand is higher than the leftward shift in supply: Price decreases (interest rate increases)

In following graph, D0 shifts left to D1 and S0 shifts left to S1, intersecting at point B with lower price P1 and lower quantity Q1.

(2) Leftward shift in demand is lower than the leftward shift in supply: Price increases (interest rate decreases)

In following graph, D0 shifts left to D1 and S0 shifts left to S1, intersecting at point B with higher price P1 and lower quantity Q1.

(3) Leftward shift in demand is equal to the leftward shift in supply: Price stay the same (interest rate stays same)

In following graph, D0 shifts left to D1 and S0 shifts left to S1, intersecting at point B with same price P0 and lower quantity Q1.