1. Explain the factors that shift the demand curve for bonds.

The factors that shift the demand curve for bonds are:
a) Wealth.
When the economy is growing rapidly in a business cycle expansion and wealth is
increasing, the number of bonds demanded at each bond rice increases, shifting
the demand for bonds to the right. Similarly, when income and wealth are falling
during recessions, the demand for bonds falls, and the demand curve shifts to the
left. Another factor that affects wealth is the marginal propensity to save (MPS). If
households save more, then wealth increases and the demand for bonds rises,
hence, the demand curve shifts to the right. Conversely, if people save less, wealth
and demand for bonds decreases, and the demand curve shifts to the left.

b) Expected Return.
The expected return on an asset measure how much an investor gains from
holding that asset. Therefore, a rise in the expected return increases the demand
for bonds, shifting the demand curve to the right. A change in the expected return
on alternative assets can also show the demand curve for a bond. If people
became more optimistic about stock markets and expected higher stock prices and
capital gains, the expected return on stocks would rise. Resultantly, the expected
return on bonds relative to a stock would fall, causing a decrease in the demand for
bonds, where demand shifts to the left.

c) Relative Riskiness.
The increase in the riskiness of bonds results in higher interest rates, which lowers
the prices of bonds. This means the demand curve shifts to the left. On the other
hand, an increase in the volatility of prices in alternative asset markets would make
bonds more attractive and shift the demand for bonds to shift to the right.

d) Expected Interest Rate.

If people believe that interest rates would be higher in the next period, then the
expected return today would fall, and hence, the quantity demanded would fall at
each interest rate. This shifts the demand curve to the left. On the other hand,
lower expected interest rates increase the demand for bonds and shift the demand
curve to the right.

e) Liquidity.
The increase in liquidity cause the quantity of bonds demanded at each interest
rate to increase, leading to an increase in the demand for bonds, and the demand
curve shifts to the right. On the same token, an increase in the liquidity of
alternative assets decrease the demand for bonds and shifts the demand curve to
the left.

f) Expected Inflation.
An increase in expected inflation would lead to higher prices on real assets and
hence higher nominal capital gains. The resulting increase in the expected return
on real assets today would lead to a fall in the expected return of bonds relative to
the expected return on real assets, and thus cause the demand for bonds to fall.
2. Explain the factors that shift the supply curve for bonds.

The factors that shift the supply curve for bonds are:
1. Profitability of Investment.
If the firm expects to make more profitable investments, it will be willing to
borrow more to finance these investments. Therefore, the quantity of bonds
supplied at any given price will increase. This shifts the supply curve to the right.

b) Expected Inflation.
The real cost of borrowing is measured by real interest rates, which is equal to
the nominal interest rate minus the expected inflation rate, as stated by the
Fisher equation: ir = i - πe. A higher level of expected inflation decreases the real
cost of borrowing. This makes borrowers more eager to borrow. This shifts the
supply curve to the right.

c) Government Deficits.
The government sells bonds to finance government deficits. When government
deficits are large, the government will sell more bonds, and thus, the quantity of
bonds supplied at each bond price or interest rate increases, shifting the supply
curve to the right.

d) Business Cycle Expansion.

Expansions can increase the expected profitability of investments, and hence,
increase the number quantity of bonds supplied as firms will require more loans.
However, the quantity demanded bonds also increases. The new equilibrium
interest rate can either rise or fall depending on whether the supply curve shifts
more than the demand curve and vice versa.

e) Corporate Taxes.
Higher taxes (as opposed to tax subsidies for investment) reduce the willingness of
the firm to sell bonds, thus shifting the supply to the left.
3. Discuss how the equilibrium in the bond market can be achieved.

A market has a mechanism to reach an equilibrium through an interaction between

buyers and sellers (issuers) of bonds.

If the price of bonds is too high (above an equilibrium price), there will be a surplus of
bonds. Sellers compete with each other to sell their bonds and cut its price (a bond
price falls to an equilibrium price). If the price of bonds is too low (below equilibrium
prices), there will be a shortage of bonds. Buyers compete with each other to purchase
bonds and bid up its price (a bond price rises to an equilibrium price).

For a given price of bond, the quantity demanded of bonds may be greater than, less
than, or equal to a quantity supplied of bonds. If the quantity demanded is greater than
the quantity supplied, then there will be a shortage. If the quantity demanded is less
than the quantity supplied, then there will be a surplus.

At level P1, there are AB units of surplus, which cause competition among sellers and
the bond price will fall from P 1 to P0 and the interest rate will rise from i1 to i0. At P2,
there are CD units of shortage, which cause competition among buyers and the bond
price will rise from P2 to P0 and the interest rate will fall from i2 to i0.