So I’m currently studying macroeconomics and I thought I understood the correlation between these 3 so I sent it to my teacher who confirmed that I was correct but then went to re-watch the recording about it and got confused when he said demand for bonds goes up then price of bonds go down and this interest rates decrease — w/ the assumption that real money demand > real money supply….

Here is the message I sent (prior to reviewing the above):

“I just wanted to verify, interest rates and bond prices are negatively correlated but the demand for bond increases and interest rates increase right?

Because if you presently have a bond and the interest rate increases, new bonds will have better rates and the demand for the currently held will decrease the price of said bond which means less $net. But the new bonds are attractive as interest rates likely won’t increase indefinitely and provide a higher yield and that yield increases when interest “inevitably” falls back down? So in a way people will generally look to buy bonds at what they assume is peak interest rates?”

Please help me understand the relation between bonds interest rates and real money supply and demand.

In: Economics

You have to differentiate between the bond when initially offered and the bond when sold at a later time.

When a bond is first issued, it has a fixed payout tied to an interest rate. Someone pays the face value of the bond to the issuer, and the issuer agrees to pay the buyer a fixed interest rate.

In this initial transaction, the interest rate is determined by the demand for the bond. If demand is high, the interest rate is lower. If demand is low, the interest rate is higher.

After a bond is issued, the owner can sell the bond. Although the selling price at this time can be anything, the bond payout does not change. If the demand for the bond is high, the selling price for the bond increases, meaning the effective interest rate for the new owner is lower.

If the demand is low, then the selling price for the bond decreases, but the effective interest rate for the new owner is higher.

An example:

Xyz, Inc. issues a bond with a face value of $10,000. The amount of interest xyz agrees to pay is based on things such as solvency of xyz and current interest rates paid by governments and other companies.

Suppose the xyz bonds are issued with an annual interest rate of 5% with the bond to be redeemed in 10 years. Joe buys one bond and therefore will get $500 per year from Xyz plus $10,000 at the end of 10 years.

Five years later,, Joe then needs money for a hair transplant. He then puts his bond up for sale.

Situation 1: interest rates are at 5%. Thus, the bond is worth $10,000.

Situation 2 : interest rates have fallen to 1%. Thus, the bond is worth more than $10,000. If someone buys the bond for $11,000, then the new buyer will still receive $500 per year, so the effective interest rate is less than 5%.

Situation 3: interest rates have climbed to 10%. The bond is worth less than $10,000. If someone buys the bond for $5000, the new buyer still receives $500 per year, so the effective interest rate is higher than 5%.