BOND VALUATION: OVERVIEW ON INTEREST RATES

What determines interest rates?

1. Demand on bonds

At higher prices, the quantity demanded of bonds falls. Also, note that higher bond
prices are associated with lower interest rates because bond prices and interest rates
are negatively related.
2. Supply of bonds

Higher bond prices mean lower interest rates, which encourage borrowing, holding
other factors constant.

3. Increase in expected inflation (Fisher Effect)

When expected inflation rises, nominal interest rates will rise.

4. An economic slow down

In general, where both bond supply and bond demand decrease, the total effect on the
equilibrium interest rate is uncertain. Here the shift in bond supply is larger than the shift in bond
demand, so the interest rate falls. This is consisting with the data on interest rates and the
business cycle: nominal interest rates tend to fall during recessions and rise during expansions.
In other words, interest rates are procyclical.