Question

(a) What will happen to the price of bond and interest rate when there is:    ...

(a) What will happen to the price of bond and interest rate when there is:

    (i) an excess supply of bonds?

    (ii) an excess demand for bonds?

    Use diagrams to aid your explanation.   

(b) (i) Why does the segmented market theory suggest the bonds of different maturities are not substitutes?

    (ii) How does the segmented market theory explain the upward sloping curve? ( 7 marks)

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Answer #1

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1 supply shifts from so to S1. As a result price falls from p1 to po. Since prices and interest rates are inversely related, interest rate rises

2 demand rises from Do to D1. Consequently price rises from p1 to p2. As a result interest rate falls

3 Because investors match maturity of their assets with liabilities.They do not prefer to invest in assets whose maturity is different from their liabilities

4 Because most investors prefer short term assets. They will hold long term assets only if interest rate in longrun is greater

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