Kenneth R. Szulczyk
Demand and supply functions intersect at one point, the equilibrium. Equilibrium reflects a
state of rest. As long as the supply or demand function does not change, then the price and
quantity remain where they are. We show supply and demand functions in Figure 3. At this
point, the quantity demanded equals the quantity supplied for bonds. The Q and P represent
equilibrium quantity and price. Using the present value formula, we can deduce what happens to
the market interest rate.
What would happen to the bond market if the bond’s price exceeds the equilibrium price?
Consequently, the quantity supplied is greater than quantity demanded, creating a surplus.
Businesses and government sell more bonds because the price of bonds is high, and interest
rates are low. However, the investors do not buy these bonds because the high price and low
interest rates. Thus, the bond’s price falls until restoring equilibrium at P* again.
Figure 3. Supply and demand for bonds
What would happen in the market if the price of bonds were lower than the equilibrium
price? Quantity supplied becomes less than quantity demanded, creating a shortage. Bond prices
are low, and interest rates are high. Consequently, the investors have a large demand for bonds
because the bonds make a good investment. However, businesses and government do not sell
bonds for a low price and high interest rate. Thus, the bond’s price must increase until
equilibrium is restored at P* again, decreasing the market interest rates. Therefore, the market
always gravitates to equilibrium and consistently eliminates shortages and surpluses as long as a
government does not interfere in the market.
Demand function can shift because a factor has changed. Please know the difference
between a movement along a demand curve and a demand function shift. We show a decrease in
quantity demanded in Figure 4. Investors demand more bonds as we move from point A to point
B. Economists call this a change in “quantity demanded.” Investors increase quantity demanded
because the price of bonds became cheaper. Consequently, a factor has changed the supply
function and not the demand function. If an outside factor affects the demand function, then the