You are here

The Bond Market and Macroeconomic Performance

25 April, 2016 - 09:12

The connection between the bond market and the economy derives from the way interest rates affect aggregate demand. For example, investment is one component of aggregate demand, and interest rates affect investment. Firms are less likely to acquire new capital (that is, plant and equipment) if interest rates are high; they’re more likely to add capital if interest rates are low.

If bond prices fall, interest rates go up. Higher interest rates tend to discourage investment, so aggregate demand will fall. A fall in aggregate demand, other things unchanged, will mean fewer jobs and less total output than would have been the case with lower rates of interest. In contrast, an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive. That change may boost investment and thus boost aggregate demand.

Figure 25.2 shows how an event in the bond market can stimulate changes in the economy’s output and price level. In Panel (a), an increase in demand for bonds raises bond prices. Interest rates thus fall.

Lower interest rates increase the quantity of investment demanded, shifting the aggregate demand curve to the right, from AD1 to AD2 in Panel (b). Real GDP rises from Y1 to Y2; the price level rises from P1 to P2. In Panel (c), an increase in the supply of bonds pushes bond prices down. Interest rates rise. The quantity of investment is likely to fall, shifting aggregate demand to the left, from AD1 to AD2 in Panel (d). Output and the price level fall from Y1 to Y2 and from P1 to P2, respectively. Assuming other determinants of aggregate demand remain unchanged, higher interest rates will tend to reduce aggregate demand and lower interest rates will tend to increase aggregate demand.

media/image331.png
Figure 25.2 Bond Prices and Macroeconomic Activity
 

An increase in the demand for bonds to D2 in Panel (a) raises the price of bonds to Pb2, which lowers interest rates and boosts investment. That increases aggregate demand to AD2 in Panel (b); real GDP rises to Y2 and the price level rises to P2.An increase in the supply of bonds to S2 lowers bond prices to Pb 2 in Panel (c) and raises interest rates. The higher interest rate, taken by itself, is likely to cause a reduction in investment and aggregate demand. AD1 falls to AD2, real GDP falls to Y2, and the price level falls to P2 in Panel (d).

In thinking about the impact of changes in interest rates on aggregate demand, we must remember that some events that change aggregate demand can affect interest rates. We will examine those events in subsequent chapters. Our focus in this chapter is on the way in which events that originate in financial markets affect aggregate demand.