1. Money and Banking
Lecture 15

2. Review of the Previous Lecture
Bonds
Yield to Maturity
Current Yield
Holding Period Returns
Bond Supply, Demand and Equilibrium

3. Topics under Discussion
Factors Influencing Bond Supply
Factors Influencing Bond Demand
Bond and Risk
Default Risk
Inflation Risk
Interest Rate Risk

4. Factors that shift Bond Supply
Changes in government borrowing
Any increase in the government’s borrowing needs increases the quantity of bonds outstanding, shifting the bond supply curve to the right.
This reduces price and increases the interest rate on the bond.

5. Factors that shift Bond Supply
Changes in business conditions
business-cycle expansions mean more investment opportunities, prompting firms to increase their borrowing and increasing the supply of bonds
As business conditions improve, the bond supply curve shifts to the right.
This reduces price and increases the interest rate on the bond.
By the same logic, weak economic growth can lead to rising bond prices and lower interest rates

6. Factors that shift Bond Supply
Changes in expected inflation
Bond issuers care about the real cost of borrowing,
So if inflation is expected to increase then the real cost falls and the desire to borrow rises, resulting in the bond supply curve shifting to the right
This reduces price and increases the interest rate on the bond.

7. Factors that shift Bond Supply

8. Factors that shift Bond Supply

9. Factors that shift Bond Demand
wealth
An increases in wealth shift the demand for bonds to the right as wealthier people invest more.
This will happen as the economy grows during an expansion.
This will increase Bond Prices and lower yields.

10. Factors that shift Bond Demand
Expected inflation
A fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering the yield and increasing the Bond’s price.

11. Factors that shift Bond Demand
Expected return on stocks and other assets
If the return on bonds rises relative to the return on alternative investments, the demand for bonds will rise.
This will increase bond prices and lower yields.

12. Factors that shift Bond Demand
Risk relative to alternatives
If a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right.

13. Factors that shift Bond Demand
Liquidity of bonds relative to alternatives
When a bond becomes more liquid relative to alternatives, the demand curve shifts to the right.

14. Factors that shift Bond Demand

15. Factors that shift Bond Demand

16. Equilibrium
An increase in expected inflation shifts bond supply to the right and bond demand to the left.
The two effects reinforce each other, resulting in a lower bond price and a higher interest rate

17. Equilibrium

18. Equilibrium
A business-cycle downturn shifts the bond supply to the left and the bond demand to the left.
In this case the bond price can rise or fall, depending on which shift is greater.
But interest rates tend to fall in recessions, so bond prices are likely to increase

19. Equilibrium

20. Bonds and Risk Sources of Bond Risk Default Risk Inflation Risk
Interest-Rate Risk

21. Summary Factors Influencing Bond Supply
Factors Influencing Bond Demand
Equilibrium Conditions