Question

5. This quotation is from a recent article in The Economist magazine, “Bond yields rose in January as investors worried about a return of inflation and the trillion-dollar deficits likely after America’s recent tax cuts.” If you’d like to read the full article, you can at https://goo.gl/GPYC8R

a. Using a supply and demand diagram accompanied by a couple of sentences to explain, tell my why a fear of rising future inflation would cause bond yields to rise.

b. Using a supply and demand diagram accompanied by a couple of sentences to explain, tell my why a fear of increased future government budget deficits would cause bond yields to rise.

Answer 1

a) Higher inflation to be expected in future will encourage investors to demand more loanable funds while this will also reduce the supply of loanable funds. These two events will shift the demand curve for loanable funds to the right and supply to the left so that interest rate rises. In the bond market, higher expected inflation will discourage investments so demand for bonds falls while supply of bonds rises (as a function of price) so that bond price will fall due to demand decrease and fall again due to supply increase. Since bond price is inversely related to its yield, a reduction in price will result in an increase in its yield.

b) A fear of increased future deficits by government will encourage the market participants to form a presumption that it willbe financed from loanble funds and government will therefore release bonds. In the bond market increase in supply of bonds will shift the supply curve and so price of bonds will fall. Since bond price is inversely related to its yield, a reduction in price will result in an increase in its yield.