Question

For each of the following, describe in words, the shift in the supply and/or demand for bonds for each case. Also, answer the question what happens to price and interest rates under each case (Don't write on paper I need to copy it.)

1. There is an increase in peoples’ wealth
2. People become more pessimistic about stock market returns relative to that of bonds
3. There is an increase in the expected rate of inflation

Answer 1

1. There is an increase in peoples’ wealth: when people's wealth increases people's saving potential will go up hence the demand for bonds will go up, the price for bonds will also go up. but due to the increased supply of loanable funds, interest will go down.
2. People become more pessimistic about stock market returns relative to that of bonds: Then relative demand for bonds go up as people will more prone to save in bonds now. hence the bond price will go up. here we cannot say anything about the rate of interest as other factors in the stock market will also determine the rate of interest.
3. There is an increase in the expected rate of inflation: people will now think that as the value of the currency holding is going down they should invest in the bonds to earn some returns/minimise the depreciation of the value of the currencies. hence the demand for bonds will go up and the bond price will go up. and due to the increase in the supply of loanable funds the interest rate will go down.

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