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~ The Way the Bond Market Works ~

"Let me now be more specific about the way the bond market works in this economy. I have assumed that the bond market determines the interest rate on the bonds. In fact, bond markets typically determine not the interest rate but rather the price of bonds. The interest rate can then be inferred from the price. Let us look at the relation between interest rate and price more closely.

Let the bonds be one-year bonds that promise payment of $100 a year hence. In the United States, such bonds, when issued by the government and promising payment in a year or less, are called Treasury bills, or simply T-bills. Thus, you can think of the bonds in our economy as one-year T-bills. Let their price today be $PB, where stands B for "bond." If you buy the bond today and hold it for a year, the rate of return on holding the bond for a year is equal to ($100 - $PB) / $PB (what you get for the bond at the end of the year minus what you pay for the bond today, divided by the price of the bond today). Thus, the interest rate (i) on the bond is defined by

i = ( $100 - $PB ) / $PB

For example, if $PB is equal to $95, the interest rate is equal to $5 / $95, or 5.3 percent. If $PB is $90, the interest rate is 11.1 percent. The higher the price of the bond, the lower the interest rate.

Equivalently, if we are given the interest rate, we can infer the price of the bond. Reorganizing the formula above, the price ($PB) of a one-year bond is given by

$PB = $100 / ( 1+ i )

The price of the bond is equal to the final payment divided by 1 plus the interest rate. Thus, if the interest rate is positive, the price of the bond is less than the final payment. And the higher the interest rate, the lower the price today. When newspapers write that "bonds markets went up today," they mean that the prices of bonds went up and therefore that interest rates went down.

Let's now look at the effects of an open market operation in which the central bank increases the supply of money-an expansionary open market operation. In such a transaction, the central bank buys bonds in the bond market and pays for them by creating money. As it buys bonds, the demand for bonds goes up and thus the price of bonds goes up. Equivalently, the interest rate on bonds goes down. When, instead, the central bank wants to decrease the supply of money-and thus does a contractionary open market operation-it sells bonds. This leads to a decrease in their price, and thus to an increase in the interest rate......."

Olivar Blanchard, "Macroeconomics", p. 89, 1997.