Question

Assume that people were expecting 4% inflation rate over the coming year, but new data suggest that the economy is growing less than previously thought, so investors lower their inflation expectations to 2%. Illustrate in your graph how this change in inflation expectations will affect bond demand and/or bond supply. Mark clearly the direction of any shift(s) and the new and old equilibrium price and quantity.

Answer 1

Assuming at expected inflation rate of 4% the bond market was in equilibrium.

Demand for Bonds

Investors in bonds are given a fixed amount of money that is not adjusted for inflation. So, higher the inflation lesser the value of their future income and vice-versa.

So , in this case where the expected inflation has fallen , the investors are willing to lend more money so the demand curve will shift to the right indicating an increase in demand.

Supply for Bonds

Borrowers value a high inflation rate. They will be willing to pay the fixed interest on the money borrowed which is of less value than what they had borrowed.

So, if there is a high inflation they are more willing to borrow and vice-versa.

So, in this case a fall in the expected inflation rate will make the borrowers less interested in supplying bonds and hence, supply falls shifting the supply curve leftwards.

Graphical Representation of Demand and Supply

From the graph it can be observed that the rightward shift of the demand curve ( D1 to D2) and leftward shift of the supply curve from (S1 to S2 ) has led to an increase in the price of the bonds and also a slight increase in the quantity.  This increase in the bond price will reduce the interest rates.