Week 6

Question 1

How does wealth affect bonds?

Answer 1

-When the economy is growing rapidly in a business cycle
expansion and wealth is increasing =⇒ the quantity of bonds demanded at each bond price (or interest rate) ↑ =⇒ the
demand curve Bd
shifts to the right
- When the economy is in a recession and wealth is falling =⇒ the quantity of bonds demanded at each bond price Bd ↓ =⇒ the demand curve Bd shifts out to left.

Question 2

What happens with bonds with maturity?

Answer 2

-For bonds with maturities of greater than one year, the
expected return may differ from the interest rate.
- For example, a rise in the interest rate on a long-term bond (maturity > 1 year) from 10% to 20% would lead to a sharp decline in price and a very large negative return

Question 3

What is the expected returns of bond?

Answer 3

• So we see that when interest rates are expected to ↑ =⇒
  bond price ↓ =⇒ the expected return on long-term bonds ↓=⇒ the demand for bonds ↓ =⇒ demand curve shifts to the
  left
• When interests rates are expected to ↓ =⇒ bond price ↑
  =⇒ the expected return on long-term bonds ↑ =⇒ the demand for bonds ↑ =⇒ demand curve shifts to the right

Question 4

What is the Expected returns of other assets?

Answer 4

-Expected returns on other assets can also shift the demand curve for bonds
- For example, if stock markets are expected to do well and
stock prices are expected to ↑ =⇒ expected returns of stocks
↑ =⇒ expected returns of bonds relative to that of stocks ↓
=⇒ demand for bonds ↓ =⇒ demand curve shifts to the left

Question 5

how does expected inflation affect demand curve?

Answer 5

-Change in expected inflation is likely to alter expected returns
on physical assets (also called real assets) such as cars and
houses
- expected inflation ↑ =⇒ prices of real assets in the future ↑
=⇒ expected nominal returns ↑ =⇒ expected bond return
relative to real assets ↓ =⇒ demand for bonds ↓
- Alternatively, you can think of this in the following way:
expected inflation ↑ =⇒ real interest rates on bonds ↓ =⇒
relative expected returns on bonds ↓ =⇒ demand for bonds ↓

Question 6

how does risk affect demand curve?

Answer 6

• If bond price is more volatile, risk (i.e. measured by standard
  deviation) associated with bonds ↑ =⇒ bonds appear less
  attractive =⇒ demand for bonds ↓ =⇒ demand curve shifts to left
• If risk in other markets (i.e. stock) ↑ =⇒ bonds more
  attractive =⇒ demand for bonds ↑ =⇒ demand curve shifts to right

Question 7

how does liquidity affect demand curve?

Answer 7

• If it’s easier to sell bonds =⇒ demand for bonds ↑ demand
  curve shifts to the right
• Similarly, liquidity of other assets ↑ =⇒ demand for bonds ↓
  =⇒ demand curve shifts to left
• For example, brokerage commissions ↓ OR transaction fees of stocks ↓ =⇒ Liquidity of stocks ↑

Question 8

What is the Expected profitability of investment opportunities?

Answer 8

-The more profitable plant and equipment investments that a
firm expects it can make the more willing firms are to borrow
to finance these investments.
- When the economy is growing rapidly (in a business cycle
expansion), investment opportunities that are expected to be profitable =⇒ supply of bonds ↑ =⇒ supply curve shifts to right
- When in a recession =⇒ fewer profitable investment opportunities expected =⇒ supply of bonds ↓ =⇒ supply
curve shifts to left

Question 9

how does expected inflation affect supply curve?

Answer 9

-For a given interest rate (and bond price), when expected
inflation ↑ =⇒ the real cost of borrowing ↓ =⇒ supply of
bonds ↑ =⇒ supply curve shifts to the right.
- when expected inflation ↓ =⇒ the real cost of borrowing ↑==⇒ supply of bonds ↓ =⇒ supply curve shifts to the left

Question 10

How does government budget affect supply curve?

Answer 10

• Treasury issues bonds to finance central government deficits
• Deficits refer to the gap between the government’s
  expenditures and its revenues (spending > revenue)
• when government deficits ↑ =⇒ supply of bonds ↑ =⇒
  supply curve shifts to the right
• When treasury is in surplus (spending < revenue) =⇒
  supply of bonds ↓ =⇒ supply curve shifts to the left
• municipal/ local governments and other government agencies
  also issue bonds to finance their expenditures, and this can
  affect the supply of bonds as well.

Question 11

Cons of using supply and demand of bonds?

Answer 11

• When you examine the effect of a variable change, remember
  we are assuming that all other variables are unchanged
• The interest rate is negatively related to the bond price, so
  when the equilibrium bond price rises, the equilibrium interest rate falls; vice versa.