In the United States, the Federal Reserve or Fed controls the money supply. It is the only entity that can produce money. However, the money supply in general remains constant. Instead, the Federal Reserve controls the money supply by buying and selling bonds. Bonds and interest rates have a negative relationship, so if the prices of bonds rise, interest rates decrease.
A bond is a type of loan. When you buy a bond, you are lending money to the entity that issued the bond. In exchange, the issuer is obliged to repay the original loan amount plus interest over the life of the bond. The bonds have a maturity date. The bond issuer must pay the full amount due on the maturity date. If you want to collect the bonus early, you may not receive the full value of the bond. The bonds are issued by federal and local governments, businesses and other government agencies.
What about the supply and demand for bonds when the interest rate decreases?
Low interest rates and bonds
When interest rates are low, bond prices are high. When the low interest rates cause higher bond prices and produce lower return on investment, the demand for bonds is low. However, as price of bonds that offer bonus increases, the interest rates tends to decrease.
What causes the shift in supply and demand of bonds
High rates of inflation causes the demand for bonds to fall because inflation produces lower interest rates and low returns on investment. It also increases the supply of bonds. The demand for bonds will also be low when bonds tend to be riskier than other investments and when bonds are difficult to sell. Demand for bonds will increase when wealth in the economy increases, causing people to invest more money in bonds, regardless of the price.
Decision of the Federal Reserve on interest rates:
Although several factors influence the supply and demand for bonds, which in turn influences interest rates, the Fed may also influence interest rates of bonds. When the Fed buys bonds, money supply increases and the interest rates decreases. The Fed can also influence interest rates when they sell bonds to increase revenue and decrease the money supply in the economy.