Question

For each of the following events draw a diagram illustrating the demand and supply of bonds and indicate how the equilibrium price and quantity would be affected:

a)   Expected inflation rises.

b)   An increase in brokerage commissions on stocks                                                                                                                                      

                   c)   Business people become more pessimistic about prospective investment projects.

PLEASE SHOW YOUR WORK ON HOW YOU GOT EACH ANSWER (INCLUDING STEP-BY-STEP CALCULATIONS)!

Answer 1

In the diagram below, we have shown the market for bonds with demand and supply curves for bonds. Here, we have plotted price on the Y-axis and quantity on the X-axis. Now, demand for bonds curve is downward sloping due to inverse relation between quantity demanded and price whereas, supply of bonds curve is upward sloping due to direct relation between quantity supplied and price. Equilibrium is attained at the point where the two curves intersect.

1) If expected inflation rises , supply of bonds rises whereas, demand for bond falls. As a result, supply of bonds curve shifts to the right whereas demand for bonds curve shifts to the left. Equilibrium price level must fall down and equilibrium quantity may or may not change depending on the magnitude of change in demand and supply of bonds.

2) With increase in brokerage commission on stocks, demand for bonds rises. This is because with higher price of stocks, people are more attracted towards purchasing bonds than stocks. As a result, demand curve for bonds shifts to the right. This will cause both the equilibrium price and quantity of bonds to rise to P' and Q' respectively.

3) If business people become more pessimistic about prospective investment projects, bonds become less attractive. As a result, demand for bonds will fall. This will cause the demand for bonds curve to shift to the left (to Demand') as shown below in the diagram. Thus, both equilibrium price and quantity falls.