Relation between Bond Prices and Interest Rates
The fact that the prices of the bonds vary inversely with the interest rates is the key to understanding how it works. Something that a lot of people buy is bonds. With all the money behind the limited supply of bonds, the prices of the bonds increases and is higher than the amount of money demanded. So now listen up, what happens to the interest rates when the prices of the bonds go up? The interest rates go down. An excess amount of money increases the prices of the bonds, which diminishes the interest rates.
Imagine if everyone tried to sell his or her bonds. With all these sells, the prices of the bonds would diminish, in other words the interest rates would increase. In fact the prices of the bonds would continue reducing and the interest rates would continue increasing until it reaches an interest rate in which people are satisfied with.
It is important to understand that the movements towards the interest rates are sometimes fast. There isn’t any excess of demand or supply of money that lasts for a very long time, because quick adjustments in the prices of the bonds move the interest rates back into balance.
One important consequence that the interest rates adjust very quickly is that the government can print up any amount of money they like, knowing that the interest rates adjust themselves so that people will want to keep exactly that amount. This gives the government a political tool that is very useful to manage the economy; because they can get ahead and create an interest rate they choose to by printing up an amount of appropriate money.
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