Question

How is the equilibrium interest rate determined in the bond market? Explain why the interest rate will move toward equilibrium if it is temporarily above or below the equilibrium rate.

Answer 1

In the bond market, equilibrium interest rate is determined through the intersection of demand curve for bonds and supply curve of bonds.

In other words, the interest rate corresponding to which demand curve of bonds intersects the supply curve of bonds is the equilibrium interest interest rate in the bond market.

If interest rate in bond market is above the equilibrium interest rate then in such scenario supply of bonds will exceed the demand for bonds.

When supply exceeds the demand, there is downward pressure on price.

So, this excess of supply of bonds over demand for bonds will put the downward pressure on the interest rate. This downward pressure will remain continue till the interest rate returns to the equilibrium level.

If interest rate in bond market is below the equilibrium interest rate then in such scenario demand for bonds will exceed the supply of bonds.

When demand exceeds the supply, there is upward pressure on price.

So, this excess of demand for bonds over supply of bonds will put the upward pressure on the interest rate. This upward pressure will remain continue till the interest rate returns to the equilibrium level.