Using the supply and demand for bonds framework, explain how an increase in expected inflation affects...

Using the supply and demand for bonds framework, explain how an increase in expected inflation affects the equilibrium nominal interest rate.

Draw a clearly labeled bond market diagram to support your explanations.

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Expert Solution

An increase in the expected inflation would decrease the real interest rate , which is the real rate of return. The buyers of the bonds will decrease the demand for bonds since they knew an increase in the expected inflation would decrease their rate of return. This is shown by the leftward shift of the demand curve , at the same time an increase in the expected inflation increases the willingness to supply bonds. So the supply of bonds increases and this is a rightward shift of the supply curve.

The initial equilibrium point is A , and there is the decrease in the demand shown by leftward shift of the demand curve. The increase in the supply is shown by rightward shift of the supply curve , the new equilibrium point is B where the price of bonds has decreased.

Since the bonds price and the nominal interest rates are negatively related , a decrease in the price of bonds would increase the nominal interest rates.

Rahul Sunny answered 1 year ago

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