During the euro-area sovereign debt crisis, the spread between the yields on bonds issued by the...

During the euro-area sovereign debt crisis, the spread between the yields on bonds issued by the governments of peripheral European countries (such as Greece, Ireland, Italy, Portugal, and Spain) and those on bonds issued by Germany widened considerably. Use the model of supply and demand for bonds to illustrate how this could be explained by a change in investors' perceptions of the relative riskiness of peripheral sovereign versus German bonds.

Expert Solution

When investors perceive sovereign bonds as riskier, their demand for sovereign bonds decreases, shifting its demand curve leftward, decreasing price of sovereign bonds. Since bond price and yield are inversely related, lower bond price will increase yield on sovereign bonds. On the other hand, their demand for the less risky German bonds increases, shifting its demand curve rightward, increasing price of sovereign bonds. Since bond price and yield are inversely related, higher bond price will decrease yield on German bonds. Therefore, yield spread (= yield of sovereign bonds - yield on German bonds) will increase (widen).

In each graph, In each graph, (P) and quantity (Q) of bonds are depicted along vertical and horizontal axes. D0 & S0 are initial demand and supply curves intersecting at point A with initial equilibrium price P0 and quantity Q0.

(i) Lower demand for sovereign bonds shifts D0 leftward to D1, decreasing price to P1 and quantity to Q1.

(ii) Higher demand for German bonds shifts D0 rightward to D1, increasing price to P1 and quantity to Q1.

Rahul Sunny answered 2 years ago

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