Kenneth R. Szulczyk
equipment during a business cycle because of profit expectations, while the opposite
occurs during a recession. A decrease in business taxes increases the bond’s supply function shifting rightward. If a
government subjects a business to high taxes, then the business has a low incentive to
invest in machines and equipment or expand its production. More investment, such as
borrowing funds through the bond market, enlarges the firm, increasing its tax burden. If a
government had lowered the tax burden on businesses, subsequently, businesses would
invest more by using bonds, increasing the bond’s supply of bonds, and the bond supply
would shift rightward. A rise in expected inflation increases the bond’s supply function shifting rightward.
Inflation erodes the value of the dollar. Consequently, the value of debt decreases over
time. If businesses and government believe inflation would rise, they borrow more funds
by issuing bonds. Then, they repay their loans with “cheaper” dollars. A rise in government borrowing increases the bond’s supply function shifting rightward.
When government spends more than what it collects in taxes, the government can borrow
by issuing government bonds. The United States federal government operated with budget
deficits for the last 40 years. Every year, the U.S. government issues more debt via bonds,
and the supply of bonds keeps increasing, which raises interest rates and reduces bond
prices.Please note the supply function can shift leftward by the same four factors. You just reverse
the logic for the four factors. For example, a drop in expected inflation causes the supply
function to decrease and shift leftward. Consequently, the bond price rises while the interest rate
falls.
Interest Rates and the Business Cycle
Empirical evidence indicates that market interest rates rise during a business cycle and fall
during recessions. During a business cycle, the amount of goods and services produced in the
economy increases because businesses become optimistic about future profits and invest in
machines and equipment by issuing more bonds. Consequently, the bond's supply increases.
Moreover, if an economy produces more goods and services, the economy creates more wealth.
Investors save more and invest in the financial markets. Thus, the bond's demand increases and
the demand function shifts rightward in Figure 8.
When both the supply and demand functions shift, we know either the price or quantity
while the other variable becomes indeterminate. In this case, both functions increase, causing
the quantity of bonds to increase, but bond prices and interest rates become unknown. If you do
not believe me, then experiment with the supply and demand functions. First, increase the
demand function by a good deal, and increase the supply function by a little. Second, increase
the demand function by a little and increase the supply function by much. Consequently, the