• <b>United States Federal Reserve</b>

Money and Banking


2. Markets for Assets


In this section, we discuss supply and demand in the market for bonds. The model will determine the quantity of bonds issued and sold in the market, the price of the bond, and the interest rate paid on bonds. We discuss how changes in the market can shift the supply and/or demand for bonds, and therefore affect the equilibrium interest rate and quantity of bonds in the market. We also use the model to demonstrate why different bonds have different interest rates, depending on differences in risk, liquidity, or tax laws.


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Demand for Bonds

For the first Pencast in this section, we describe the relationship between the interest rate paid on a bond and the price of the bond. We use these concepts and describe and create a graphical model for the law of demand for bonds. [Play Pencast]


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Determinants of Demand for Bonds

In this Pencast we discuss factors besides price or interest rate that affect the demand for bonds. We illustrate how these determinants shift the demand curve for bonds. [Play Pencast]


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Supply for bonds

In this Pencast we introduce the law of bond supply and illustrate the the shape of the supply curve and the meaning of a movement along it. [Play Pencast]


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Determinants of Supply for Bonds

In this Pencast we discuss factors besides price or interest rate that affect the supply for bonds. We illustrate how these determinants shift the supply curve for bonds. [Play Pencast]


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Bond Market Equilibrium

Here we combine what we know about the supply for bonds and the demand for bonds to determine the quantity of bonds that will be issued in equilibrium and what interest rate / price of bonds will prevail. Then we take what we know about a shift in the supply of bonds, and illustrate how this changes the quantity, price, and interest rate. [Play Pencast]


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Equilibrium Effect of Expectations

Here we look at the equilibrium effects in the bond market from a change in expectations, where bond buyers (i.e. savers or lenders) worry that the possibility of a bond default is more likely, lowering the expected return from holding a bond. We show what curves shift in the bond market, and what the consequence is for the equilibrium. [Play Pencast]


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Equilibrium Effect of Improved Liquidity

Here we look at the equilibrium effects in the bond market from a change in liquidity. The liquidity of an asset is the degree to which is easy and costless to sell the asset on a secondary market. We demonstrate the effect an improvement in liquidity has on the bond market equilibrium. [Play Pencast]


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Equilibrium Effects of Government Policy

Here we look at the equilibrium effects of two examples of government policy that influence the decision of bond sellers (i.e. borrowers). In the first, we examine what happens when the government increases taxes on business revenue. In the second, we examine what happens when the government gives business tax credits or subsidies for capital improvements. [Play Pencast]


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Equilibrium Effect of Interest Rate Expectations

Here we look at the equilibrium effects in the bond market from a change in expectations concerning future interest rates. Interest rates and bond prices are inverses of one another, so if interest rates were to increases, then bond prices will decrease. Expectations of interest rates therefore correspond to expectations concerning capital gains or losses. We show the equilibrium effects when bond buyers (i.e. lenders / savers) expect that interest rates will soon increase. [Play Pencast]


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Equilibrium Effect of Inflation Expectations

Here we look at the equilibrium effects in the bond market from a change in expectations concerning future inflation rates. Higher prices in the future lead to lower real purchasing power for future cash flows that lenders earn from owning a bond and that borrowers pay having sold a bond. Because this expectation affects the behaviors of both bond buyers and sellers, it shifts both the demand and the supply of bonds. [Play Pencast]


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Default Risk Premium

We look at bond market equilibrium outcomes for two types of bonds: a risk-free bond and a bond with a higher probability of a default. We compare the outcomes and identify the risk premium, or the higher rate of interest, paid on bonds that carry a higher risk of default. [Play Pencast]


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Liquidity Premium

We look at bond market equilibrium outcomes for two types of bonds: a highly liquid bond and a bond that is less liquid, i.e. one that take more time or is more costly to sell on a secondary market. We compare the outcomes and identify the liquidity premium, or the higher rate of interest, paid on bonds that are less liquid. [Play Pencast]


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Municipal Bonds and Income Taxes

Municipal bonds often pay a lower interest rate than U.S. federal government bonds, despite the fact that they are usually less liquid and more risky. The reason is that municipal bonds are tax deductible, so the difference in interest rates reflects only the before-tax return on the bond. We make up some numbers for a municipal bond and U.S. Treasury bill and show the before-tax and after-tax returns from owning each bond. [Play Pencast]


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