6.3Bonds: supply, demand and price

At any particular time the total quantity of securities available for purchase consists

of those securities which rms and other organisations are issuing to nance current

borrowing needs, together with all those securities issued in the past. Thus, as with

bills, we must recognise that by far the greater part of securities offered for sale at

any particular time are existing or ‘second-hand’ securities. This contrasts with our

normal assumption in economics that ‘supply’ refers to a ow of something taking

place over a period of time. The supply of securities is a stock.

This means of course that a decision by an investor to purchase shares or govern-

ment bonds is not normally a decision which involves making new funds available

to a borrower. The borrowing and lending which brought the securities into existence

was done in the past, maybe a long time ago. A decision today to buy, say, Marks

and Spencer shares is a decision to accept ownership of an existing debt, transferred

from someone else who may also not have been the original lender.

In these circumstances it is perhaps tempting to view the immense trade in existing

securities that takes place each day as unimportant to organisations’ borrowing needs

and therefore to the real economy. However, a well-developed and active market for

existing securities, the secondary market, is important in supporting the market for

new issues of securities, the primary market. People are willing to buy new issues on

the existing terms precisely because they know there is an active secondary market

in which they can transfer the debt if they wish. We shall also see in a moment that

trading in the existing stock of securities effectively determines the cost and other

terms on which new capital can be raised.

In Figure 6.1 we have depicted the stock of some existing bonds as a vertical line.

The gure also includes a demand curve showing equilibrium between the stock

of bonds in existence and the demand for it at a price P. We need to be careful in

our interpretation of this equilibrium. Remember that the supply curve Sindicates

a xed stock. Equilibrium must therefore mean that this stock of bonds is willingly

held at the price P. However, this does not mean that no trading is taking place.

It is quite possible that some people feel that the price is rather high (in the light of

conditions which we shall discuss more fully in a moment). They will be selling. But

provided that these sellers are matched by an equal number of buyers who judge

that the bond is cheap, the total stock of bonds will still be held at the current price

which will be stable.

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				6.3 Bonds: supply, demand and price

Figure 6.1

Notice that we have drawn the supply curve vertically. This is because we are look-

ing at the market in the short run and in the short run the stock is xed independently

of the price of the bonds.This is different from the normal case in economics where

we are often looking at the supply of a good being produced by a rm. In this case

a rise in price is usually assumed to cause an increase in output and so we draw the

supply curve with an upward slope.

However, over a longer period, the stock of bonds can expand as the result of

several forces which we might distinguish as ‘long-run’ and ‘medium-run’. In the

long run, rising real income and wealth will themselves encourage more borrowing

and lending and, other things being equal, bonds will share in that expansion in

proportion to their existing importance to rms’ borrowing needs. Although the UK

has recently seen years of budget surplus, the historical norm has been for decits

or ‘positive’ public sector net cash requirements (PSNCRs). As regards the supply of

government bonds, therefore, this has been a major inuence in the long run.

For medium-term changes we have to look to factors which cause a change in

the attractiveness of this form of borrowing relative to other forms. Conceivably the

cost of alternative forms of borrowing, from banks for example, could rise relative to

the cost of issuing bonds. More likely, in practice, are changes in non-price variables.

At various times, in response to monetary policy, banks have had either to ration

their lending or direct it to favoured areas of the economy. This would push some

marginal nancing decisions towards bond or equity nance. Changes in the struc-

ture of the securities markets, making them larger, more competitive, operating

with lower commissions and so on, might have the same effect. This was one of the

arguments in favour of the changes introduced to the London Stock Exchange in

October 1986.

We noted above that the public sector’s annual borrowing requirement was the

major source of bond issues in the long run. In the short run, policy decisions will

lead to variations in the proportion of the PSNCR that is funded by bond sales. A

tight monetary policy, for example, would require the PSNCR to be largely funded

by bond issues, or even to be ‘overfunded’. Companies will try to issue xed-interest

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Chapter 6 • The capital markets

Box 6.1

Increases in the stocks of equities and bonds – long- and medium-run inuences

Equities

Bonds

Long-run	1.Economic growth	1.Economic growth
	2.Ination	2.Ination
		3.PSNCR

Medium-run	3.	Rise in cost of alternative	4.	Rise in cost of alternative
		sources of capital		sources of capital
	4.	Reimposition of bank lending	5.	Reimposition of bank lending
		controls		controls
	5.	Reduction in new issue costs	6.	Reduction in new issue costs
	6.	High equity prices	7.	Tighter monetary policy
			8.	Expected higher future
				interest rates
			9.	High bond prices

debt when interest rates are low, or at least when they expect that the probability of

higher future rates is greater than the probability of lower future rates. These supply

inuences are summarised in Box 6.1, as though acting to increase supply. When they

do so, the stock of bonds will expand and the supply curve will shift to the right,

as in Figure 6.2. A useful exercise would be to work out how each of the inuences

could work in reverse and shift the supply curve to the left.

We said above that we draw the supply curve vertically because we are looking at

the situation in the short run where the stock of bonds cannot increase in response

	Figure 6.2
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