2. Often a sharp fall in stock market causes a fall in bond rate, even though...

2. Often a sharp fall in stock market causes a fall in bond rate, even though macroeconomic factors affecting bond rates have not changed (e.g. October 1987). How would the loanable funds theory explain this phenomenon?

Expert Solution

Loanable funds theory states that demand for loanable funds arises for the purposes of investment, hoarding and dissaving. Now a sharp fall in stock market causes a fall in bond rate, even though macroeconomic factors affecting bond rates have not changed. This is mainly due to factors that hoarding elements come into picture.

It should be noted that bond prices fluctuate with changing market sentiments as it affects the demand situation for bonds in a significant manner. A sharp fall in the stock markets will weaken the market sentiment and hence as per the loanable funds theory funds will be used more for the purpose of hoarding. This is because in the times of falling stock markets people will hoard cash as idle cash balance so as to ensure and maintain their liquidity levels. As demand for loanable funds for hoarding will increase then demand for bonds will reduce considerably and this will cause a fall in bond rates.

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