The keys to understanding why “the” interest rate changes over time are simple price theory (supply and demand), the theory of asset demand, and the liquidity preference framework of renowned early twentieth-century British economist John Maynard Keynes. [1] Like other types of goods, bonds and other financial instruments trade in markets. The demand curve for bonds, as for most goods, slopes downward; the supply curve slopes upward in the usual fashion. There is little mystery here. The supply curve slopes upward because the price of bonds increases, and ceteris paribus, borrowers (sellers of securities) will supply a higher quantity, just as producers facing higher prices for their wares will supply more cheese or automobiles. As the price of bonds falls, or as the yield to maturity that sellers and borrowers offer increases, sellers and borrowers will supply fewer bonds. (Why sell ’em if they aren’t going to fetch much?) The demand curve for bonds slopes downward for similar reasons. When bond prices are high (yields to maturity are low), few will be demanded. As their price falls (their yields increase), investors (buyers) want more of them because they are increasingly good
deals.
The market price of a bond and the quantity that will be traded is determined, of course, by the intersection of the supply and demand curves.
The equilibrium price prevails in the market because, if the market price were temporarily greater
than p, the market would be glutted with bonds. In other words, the quantity of bonds supplied would exceed the quantity demanded, so sellers of bonds would lower their asking price until equilibrium was restored. If the market price temporarily dipped below p, excess demand would prevail (the quantity demanded would exceed the quantity supplied), and investors would bid up the price of the bonds to the equilibrium point.
NYC Journals 