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Interest Rates and Bond Prices
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If nominal interest rates decrease due to a leftward shift in money demand, how would this affect existing bond prices?

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Choose the Best Answer

A

Existing bonds will increase in value because they offer higher returns than new bonds.

B

Existing bonds will decrease in value as new bonds become more attractive.

C

Existing bonds will remain unaffected as interest rates only influence new bond issues.

D

Existing bonds will decrease in value due to a general decline in the bond market.

Understanding the Answer

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Answer

When nominal interest rates decrease, the prices of existing bonds typically increase. This happens because bond prices and interest rates move in opposite directions. If interest rates drop, new bonds will offer lower returns, making existing bonds with higher rates more attractive. For example, if you own a bond that pays 5% interest and new bonds are only paying 3%, your bond becomes more valuable because it pays more than the new ones. Therefore, as demand for your bond increases, its price goes up.

Detailed Explanation

When interest rates go down, existing bonds become more valuable. Other options are incorrect because This idea suggests that new bonds are always better; This option thinks interest rates only affect new bonds.

Key Concepts

Interest Rates
Bond Prices
Monetary Policy
Topic

Interest Rates and Bond Prices

Difficulty

hard level question

Cognitive Level

understand

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