Or Business Cycle Expansions

We now can use our knowledge of how supply and demand curves shift to analyze how the equilibrium interest rate can change. The best way to do this is to pursue several applications that are particularly relevant to our understanding of how monetary policy affects interest rates.

Study Guide Supply and demand analysis for the bond market is best learned by practic ing applications. When there is an application in the text and we look at how the interest rate changes because some economic variable increases, see if you can draw the appropriate shifts in the supply and demand curves when this same economic variable decreases. While you are practicing applications, keep two things in mind:

1. When you examine the effect of a variable change, remember that we are assuming that all other variables are unchanged; that is, we are making use of the ceteris paribus assumption.

2. Remember that the interest rate is negatively related to the bond price, so when the equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.

Changes in Expected Inflation: The Fisher Effect

We have already done most of the work to evaluate how a change in expected inflation affects the nominal interest rate, in that we have already analyzed how a change in expected inflation shifts the supply and demand curves. Figure 5 shows the effect on the equilibrium interest rate of an increase in expected inflation.

Suppose that expected inflation is initially 5% and the initial supply and demand curves B1 and Bd1 intersect at point 1, where the equilibrium bond price is Px and the equilibrium interest rate is ix. If expected inflation rises to 10%, the expected return on bonds relative to real assets falls for any given bond price and interest rate. As a result, the demand for bonds falls, and the demand curve shifts to the left from Bd1 to Bd2. The rise in expected inflation also shifts the supply curve. At any given bond price and interest rate, the real cost of borrowing has declined, causing the quantity of bonds supplied to increase, and the supply curve shifts to the right, from B s1 to B s2.

When the demand and supply curves shift in response to the change in expected inflation, the equilibrium moves from point 1 to point 2, the intersection

FIGURE 5 Response to a Change in Expected Inflation

When expected inflation rises, the supply curve shifts from Bj to B2, and the demand curve shifts from Bj to Bj. The equilibrium moves from point 1 to point 2, with the result that the equilibrium bond price (left axis) falls from P1 to P2 and the equilibrium interest rate (right axis) rises from i1 to i2. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.)

Price of Bonds, P Interest Rate, i (P increases T ) (i increases i)

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