Using the supply and demand for bonds framework, show and explain what effect will a sudden...

Using the supply and demand for bonds framework, show and explain what effect will a sudden fall in the expected inflation have on interest rates of bonds. Fully explain and show the diagram.

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Expert Solution

A bond is an investment which represents a loan. Bonds are typically issued by government and or corporations who want to borrow money. A borrower who issues the bond promises to pay back the amount along with some interest to the lender. The price of a bond and the interest rates are inversely related because at higher interest rates lenders are more willing to give loans and hence supply increases which decreases the price and vice-versa.

A bond holder is promised to pay a fixed amount of money in the future. So if in future the inflation increases, the value of the money decreases and if inflation decreases the value of the money will be relatively higher than what it is now.

So when there is a sudden fall in the expected inflation, investors will be more willing to lend money because a particular amount of money in the future will have a comparatively higher value than what it is now. This leads to a rise in the demand for bonds, with increase in the demand the price of bonds will rise and hence the interest rates will fall.

This can be seen graphically as -

Rahul Sunny answered 1 year ago

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