Chapter 3 - Bonds and Loanable Funds

Chapter 3 – Bonds and Loanable Funds

3-1a Bonds Defined

  • Financial Markets: Place where savers and borrowers interact.

  • History: Originally, bonds were physically printed promises to repay. Currently, most are issued electronically.

  • Example: The Pacific Railroad bond funded the construction of the Western Pacific Railroad.

  • Bond: A legal contract promising repayment with interest. Issued by corporations, governments, or agencies.

  • Coupon Rate: The interest paid to bondholders. Historically, interest payments were redeemed via physical coupons.

  • Face Value: The original loan amount of the bond, also known as bond principal.

3-2 Bond Prices and Yields
  • Secondary Bond Market: Market for previously issued bonds.
  • Issuer: Receives face value and commits to pay that amount at maturity, along with coupon interest.
3-2a Prices of Bonds
  • Market Price of a Bond: Present value of expected cash flows.
  • Cash Flows involve:
    • C = coupon payment per period
    • Face = principal or face value of the bond
    • k = interest rate per period
    • n = number of periods
3-2a Prices of Bonds (continued)
  • Par: Market price equals the face value.
  • Discount: Market price is below face value.
  • Premium: Market price is above face value.
  • Inverse Relationship: Bond prices and yields move in opposite directions.
3-3a The Supply of Bonds
  • Supply Curve: Direct relationship between price and quantity supplied.
  • The upward slope indicates suppliers offer more as price rises.
3-3b Changes in the Supply of Bonds
  • Change in Supply vs. Change in Quantity Supplied:
    • Quantity Supplied: Movement along a fixed supply curve due to price changes.
    • Supply Change: Shift in supply curve caused by non-price factors such as inflation expectations, investment credits, or budget deficits:
    • Improved business expectations: Supply increases
    • Expected inflation rises: Supply decreases
3-3c The Demand for Bonds
  • Demand Curve: Inverse relationship between price and quantity demanded.
3-3d Changes in the Demand for Bonds
  • Change in Demand vs. Change in Quantity Demanded:
    • Quantity Demanded: Movement along a fixed demand curve due to price changes.
    • Demand Change: Shift of the demand curve caused by non-price factors:
    • Increase in wealth: Demand increases
    • Increased liquidity: Demand increases
3-3e Equilibrium in the Bond Market
  • Surplus: Quantity supplied > Quantity demanded.
  • Shortage: Quantity demanded > Quantity supplied.
3-3f New Equilibrium in the Bond Market
  • Supply Increase: Decreases price but increases traded quantity.
  • Supply Decrease: Increases price but decreases traded quantity.
  • Demand Increase: Increases both price and traded quantity.
  • Demand Decrease: Decreases both price and traded quantity.
3-4a The Supply of Loanable Funds
  • The supply curve for loanable funds slopes upward.
  • Higher interest rates lead to an increased quantity of loanable funds supplied (e.g., from point A to B).
    • Suppliers: Households, firms, governments, and global savers.
3-4b The Demand for Loanable Funds
  • The demand curve for loanable funds slopes downward.
  • Factors affecting demand for loanable funds:
    • Changes in household income expectations.
    • Changing business confidence.
    • Government deficits and global borrowing.
3-4c New Equilibrium in the Loanable Funds Market
  • Various events can shift supply (SLF) and demand (DLF) for loanable funds:
    • Increased business confidence raises DLF.
    • Increased government budget deficits raise DLF.
    • Higher saving rates increase SLF.
3-5a The Fisher Effect
  • Occurs in both bond and loanable funds markets due to inflation increases.
3-5b Business Cycles and Confidence
  • Interest rates are procyclical, varying with the economy's health.
  • Increased borrowing correlates with higher demand for loanable funds and lower bond prices, leading to higher interest rates.
Critical Thinking / Discussion Questions
  • What are bonds and how is investment repaid? Examples?
  • Describe interest rate trends during business cycle phases. Which phase represents the current economy?
  • Explain the Fisher Effect in context to bond and loanable funds markets.