In 2007, as stock prices in general were falling, many investors began switching their funds into purchasing bonds. Surveys suggest that many of these investors did not understand the basic relationship between bond prices and interest rates. Using a numerical example, illustrate how an increase in the demand for bonds would affect the interest rate paid on bonds.

What will be an ideal response?

If there is an increase in the demand for bonds, this would increase the price paid for a particular bond, increasing the price from, for example, $500 to $600. If the bond paid guaranteed an interest payment of $20 per year, the effective rate of interest would fall from 4 percent ($20/$500 × 100) to 3.3 percent ($20/$600 × 100). Thus, the increase in the price of the bond would decrease the interest rate. The general rule is that bond prices and interest rates are indirectly related. As bond prices change, interest rates change in the opposite direction.