Question

Use the model of supply and demand for bonds to analyze the impact of each of the following on the equilibrium quantity of bonds outstanding and on equilibrium bond prices and yields. Check all the appropriate affects.

a. The market expects the Fed to hike interest rates. What is the effect of long-term bonds?

b. The price of Bitcoin becomes less volatile. What is the effect of long-term bonds?

c. In response to tariffs announced on Chinese exports, China responds by selling a large share of U.S. bond holdings. What is the effect on long-term bonds?

d. U.S. fiscal deficits are unexpectedly higher and will continue to increase. What is the effect on long-term bonds?

e. Due to recent monetary and fiscal policies and supply-side shocks, inflationary expectations increase. What is the effect on long-term bonds?

Answer 1

a. The expected hike in the interest rate by the Fed implies that the cost of financial borrowings or loans would probably increase that would eventually lead to a decrease in the long term bond prices and increasing the demand for the long term bonds. It essentially implies that as the interest rate is expected to rise, the cost of financial borrowing or loan is also expected to increase consequently leading to a lower demand for financial borrowing or loans in the future as the bond price decreases and a higher willingness to provide or offer financial loans by the savers of funds and financial institutions or an increase in the demand for bonds in the future.

b. A less volatility in the price of bitcoins would imply an increase in the demand for bitcoin investment thereby reducing the demand for domestic bonds, holding everything else constant. Hence, the demand for long-term bonds would also consequently fall as bitcoin investment becomes relatively more stable and reliable investment option thereby reducing the equilibrium quantity and price of the long-term bonds as well in the financial market. This would consequently increase the interest rate in the money or loanable funds market.

c. As China sells a large share of US bond holdings in response to the tariff imposed on Chinese goods and services export, the supply of bonds increases in the market thereby leading to an increase in the equilibrium quantity and a fall in price of the long term bonds leading to an increase in the financial or money market.

d. If the government deficit is exceedingly high and is expected to increase, the government is expected to borrow more to finance the existing and potentially increasing government deficit, thereby enhancing the overall government debt. This would cause an expected increase in the interest rate thereby raising the cost of financial borrowing or loan and decreasing the future bond prices. Therefore, the price of long term bonds decreases and the quantity demanded of the long term bonds increases.

e. Inflationary expectations due to recent monetary and fiscal policies would lead to an expected reduction in the potential interest rate implying a decrease in the cost of financial borrowing or loan. Therefore, the money demand would increase in the money or loanable funds market indicating that the supply of long-term bonds would increase leading to an increase in the equilibrium quantity of bonds and a reduction in the bond price eventually.