Question

"When demand for the bonds rises, which translates into lower interest rates on them, banks can offer homeowners lower interest rates on their underlying mortgages." Source: Nathaniel Popper, "Fed Action Spurs Broad Rally," New York Times , September 13, 2012.

Increased demand for mortgage-backed bonds should ?(increase OR decrease) the interest rates on the bonds because the increased demand will ?(lower OR raise) the price of the bonds. Since bond prices and interest rates are ?(positively inversely) related, higher bond prices would ?(raise OR reduce) the yield (interest rate) on the bonds.

Answer 1

Increased demand for mortgage-backed bonds should reduce the interest rates on the bonds because the increased demand will raise the price of the bonds. Since bond prices and interest rates are inversely related, higher bond prices would reduce the yield (interest rate) on the bonds.

However, in reality the increase or decrease in interest rate also depends on how both supply curve and demand curve shifts. An economic expansion shifts the bond supply curve to the right. Holding demand constant, that action reduces bond prices and increases the interest rate. However, the demand does not stays constant. The net effect on the interest rate, therefore, depends on how much each curve shifts.

Empirically, the bond supply curve typically shifts much further than the bond demand curve, so the interest rate usually rises during expansions (when demand increases) and always falls during recessions (when demand decreases).