ECON2210 – KPU Copyright: Rabia Aziz Spring Homework Assignment Ch5 1.
For each of the following cases use the supply and demand analysis for bonds to the show the effect on interest rates. [Must draw diagrams and give explanation to support your answers]
- Bank of Canada increases the money supply by purchasing bonds from the public.
- Inflation is expected to rise from 1% to 3%
- Economy starts moving towards a strong contraction in the business cycle
- Sudden increase in people’s expectation of future real estate prices
- Expectation of interest rates to go up
Money and Banking
When the Bank buys the bonds, it decreases the bond’s supply in the market. This decrease causes the supply curve to shift to the left. As a result, the bonds’ supply and demand occur at a higher price and a lower equilibrium interest rate, thus reducing the interest rates, as shown in figure 1.
Figure 1: Demand and Supply Curve
The Bank of Canada’s purchase of bonds causes a shift in the supply curve from S to S1. This shift also causes an increase in bond prices from P0 to P1 and a reduction in interest rates from I0 to I1.
When inflation is expected to rise from 1% to 3%, the demand for bonds decreases, the supply increases, and the interest rates increase. The decline in demand is caused by the reduction in future payments’ expected value, discouraging individuals from investing in bonds. Furthermore, investors may demand a higher interest rate to compensate for the loss of value in their investment caused by the increase in inflation. This demand leads to a rise in interest rates.
Moreover, a rise in the inflation rates makes bonds issuance more attractive to borrowers because they would more likely repay the loan with less valuable money than when they borrow in the present. Therefore, a rise in inflation triggers an increase in the supply of bonds, an increase in interest rates, and a reduction in bond prices, as shown in figure 2.
Figure 2: Increase in Inflation Rate
As shown in figure 2, a rise in inflation rate causes a shift in the demand curve to the left from DO to DI and a shift of the supply curve from SO to S1 as more bonds are supplied, and individuals demand fewer bond investments. The bond prices also decline from P0 to P1 as the interest rates rise.
When the economy moves towards a contraction in the business cycle, the bond supply curve shifts to the left as businesses tend to borrow less. The reduction in supply increases bond prices and reduces interest rates. In the demand curve, an economic contraction implies that individuals have less wealth to invest in bonds. Therefore, the demand for bonds declines, shifting the demand curve to the left. The bond prices also decrease with the demand reduction, and the interest rate increases significantly, as shown in figure 3.
An economic contraction causes a shift in the supply curve to the left from S1 to S2 and a shift of the demand curve to the left from D1 to D2. Furthermore, the interest rate and prices fall from I1 to I2 and P1 to P2, respectively.
A sudden increase in people’s expectations of future real estate prices is likely to lower the demand for bonds as they anticipate high returns from investing in real estate. Therefore, the demand curve for bonds shifts to the left as the equilibrium interest rates rise, as shown in figure 4.
If there are expectations of an increase in real estate prices, the demand for bonds will shift to the left from D0 to D1. The bond’s interest rates and prices fall from I0 to I1 and P0 to P1, respectively.
When there are expectations of interest rates to go up, people will prefer to invest more in bonds. Therefore, the demand and price of bonds will rise significantly.
As shown in figure 5, an expectation of a rise in interest rates causes a right shift of the demand curve from D0 to D1. The prices also increase from P0 to P1