This paper discusses the factors that lead to shifts in the demand and the supply curve for bonds. In the first part, the paper discusses the factors that cause a shift in the demand curve for bonds before looking into the factors that cause a shift in the supply curve for bonds. The demand curve for bonds will shift due to changes in wealth, expected relative return, Expected interest rate, inflation expectations, relative liquidity, and relative risk (Wright and Quadrini, 2016).
Increases in wealth will increase the demand for bonds causing the demand curve to shift
outward to the right, while decreases in wealth will cause the demand curve to shift inwards to the left (Wright and Quadrini, 2016).
Wealth a b c
Demand for bonds
Given an initial demand curve as b, increase in wealth will cause the demand curve to shift to c while decreases in wealth will, cause the demand curve to shift to a.
Expected relative return is the return investors expect from a particular asset as compared to the return of those other assets (Wright and Quadrini, 2016). Investors are rational wealth maximizers and therefore the demand curve for bonds will shift outwards to the right if the investor’s believe that bonds have higher expected relative return.
Expected relative return a b c
Demand for bonds
Given an initial demand curve as b, the demand curve will shift outwards to c if investors expect bonds to have a higher relative return, and it will contract and shift to c if investors expect bonds to have a lower relative return (Wright and Quadrini, 2016).
Expected interest rates affects the market value of the bonds and hence their demand. Bond prices are inversely related to interest rates. When interest rates increase, bond prices fall, consequently, the demand curve for bonds will shift inwards to the left.
Expected interest rates a b c
Demand for bonds
Given an initial demand curve as b, the demand curve will shift outwards to c if investors expect interest rates to decline, and it will contract and shift to c if investors expect interest rates to rise (Wright and Quadrini, 2016).
Relative risk refers to the investor’s assessment of the risk of bonds as compared to the risk of other assets. Investors are risk averse and therefore a rise in the relative risk will cause the demand curve for bonds to shift inwards to the left.
Relative risk a b c
Demand for bonds
Given an initial demand curve as b, the demand curve will shift outwards to c if investors assess the risk of bonds to be lower as compared to the risk of other assets (Wright and Quadrini, 2016). The demand curve will contract and shift to c if investors assess the risk of bonds to be higher as compared to the risk of other assets (Wright and Quadrini, 2016).
Relative liquidity refers to the amount of money or cash equivalents that bondholders have for investment purposes. As investor’s liquidity improves, the demand for bonds will increase (Wright and Quadrini, 2016).
Relative liquidity a b c
Demand for bonds
Given an initial demand curve as b, the demand curve will shift outwards to c if investors relative liquidity improves, while the demand curve will contract and shift to c if investors relative liquidity declines (Wright and Quadrini, 2016).
Three main factors that cause a shift in the bond supply curve, government budget, general business conditions, and inflation expectations (Wright and Quadrini, 2016). When government operates budget deficits, they usually bridge the deficit by borrowing through issuing treasury bills and bonds this causes the supply curve to shift upwards to the right (Wright and Quadrini, 2016).
Government deficit/surplus
a b c
Supply for bonds
Given an initial bond supply curve as b, if the government is operating on a budget deficit the government will issue bonds to bridge the deficit causing the supply curve to shift outwards to c. If the government is running a surplus budget, they will redeem bonds and cause the supply curve to shift inwards to a (Wright and Quadrini, 2016).
General business conditions refer to the business climate prevailing at the time. When general business conditions are good businesses are optimistic and issue more bonds to finance expansion causing the bond supply curve to shift upwards (Wright and Quadrini, 2016). On the other hand, when the general business conditions are bad, businesses are reluctant to issue bonds, and in fact, most of the businesses repay their loans in a bid to reduce their financial risk causing the bond supply curve to shift downwards.
General business conditions
b. c.
Supply for bonds
Given an initial bond supply curve as b, if the general business conditions are good, businesses will issue more bonds causing the supply curve to shift outwards to c. If the business conditions are bad, business will be reluctant to issue bonds or they will redeem bonds causing the supply curve to shift inwards to a (Wright and Quadrini, 2016).
Inflation triggers changes in the nominal interest rates. Inflation is positively correlated with nominal interest rates. Businesses are reluctant to borrow if there are expectations of inflation to rise because the nominal rates on borrowing will rise and increase the financing costs to the business (Wright and Quadrini, 2016).
Expected inflation rate
b. c.
Supply for bonds
Given an initial bond supply curve as b, if investors expect inflation rates to rise, businesses will business will be reluctant to issue bonds or they will redeem bonds causing the supply curve to shift inwards to a (Wright and Quadrini, 2016). On the other hand, if investors expect inflation rates to fall, investors will issue more bonds causing the supply curve to shift outwards to c (Wright and Quadrini, 2016).
Reference list
Wright, R. and Quadrini, V. (2016). Money and Banking 1.0 | Flat World Education. [online]
Flat World Knowledge. Available at:http://catalog.flatworldknowledge.com/bookhub/reader/30?e=wright. [Accessed 2 Mar. 2016].
