Consider the factors that affect bond demand and bond supply. Describe how the following are likely to change during a period of robust economic growth: wealth, default risk, and general business conditions. For each, state how the factor is likely to change, and discuss the implications for bond demand/supply, bond price, and yield. Bond prices tend to decrease during periods of high economic growth. What does this reveal about which of these factors is important?

Question

What will be an ideal response?

Answer 1

(i) Wealth affects bond demand and is likely to increase during an economic expansion. Households experience an increase in the value of their total assets (including stocks, for example). This leads to an increase in bond demand, increase in bond price, and decrease in yield.
(ii) Default risk affects bond demand. The risk of default is likely to decrease during an economic expansion because borrowers are more likely to honor their debts. This leads to an increase in bond demand, increase in bond price, and decrease in yield.
(iii) General business conditions affect bond supply. These improve during economic booms. This leads to an increase in bond supply, decrease in bond price, and increase in yield. If bond prices tend to decrease during periods of robust growth, this tells us that the improvement in general business conditions has a larger effect on the bond market than changes in wealth or default risk.