I know about the inverse relationship between bond prices and interest rates. However, when we talk about Liquidity Preference Theory, there we mention that an increase in interest rates leads to more demand for interest-bearing assets like bonds. Doesn't that mean that an increase in interest rates leads to higher demand for bonds, and hence higher bond prices? Is this theory contradictory?
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No it’s not contradictory, your mistake is that you claim bond is interest bearing asset but that is not generally true. Standard bond has a fixed face value and coupon rate which does not correspond to market interest rate. Hence even when an interest rate increases the coupon rate on bond is still the same.
For example, if we talk about 1000 dollar bond with 10% coupon rate, you only get a 100 coupon even if the market interest rate is 50%. You are not encouraged to pay more for the bond but less because now buying this bond is worse than buying some other asset where you get the 50% interest.
A demand for any particular bond will be 0 if its price is above the present value and infinity if it’s below. As a consequence the equilibrium price of bond will be equal to its present value. Increase in interest rate always lowers present value of already preexisting bond.
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$\begingroup$ Thank you. But doesn't it mean that the demand for newly issued bonds will increase thereby rising its price? I understand the inverse relation between interest rates and bond prices in case of preexisting bonds. $\endgroup$ Commented Mar 29 at 19:59
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$\begingroup$ @festakonik not if the new bonds are issued at the same coupon rate as the old bonds. Again bond is a fixed income security. A demand for a fixed income security will be always 0 if price is above present value and infinity if it’s below. Consider a practical example, a Swiss (or in other words risk free) zero coupon bond with face value of 1000 with maturity of one year. If the interest rate in an economy is 10% then no matter how large the demand is above price 909.09 nobody will want to buy the bond because if interest rate is truly 10% you could just park the same money in some savings $\endgroup$– 1muflon1 ♦Commented Mar 29 at 23:05
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$\begingroup$ Account. If the price for the bond comes down below 909.09 you basically have infinite money glitch, just borrow at the 10% interest buy the bond and pay the money back, so then the demand for bond would be infinite. Increase in interest rate does shift consumption (and saving is inverse of consumption) intertemporarly precisely because it means that relative price of consuming is now higher and thus relative price of saving is lower (we are moving along the demand curve). $\endgroup$– 1muflon1 ♦Commented Mar 29 at 23:11
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Let's imagine Watch that usually sells for \$50. Say, as a results of external factors, the price of the watch drops to \$30. Can we say that the "demand" for the watch increased? In a sense yes. the watch now becomes more attractive due to its price.
However, I'm not sure that in the general economic terminology we should say that the demand for the watch increased: as the demand curve remains the same - we just moved along the curve.
The same goes for bonds (in those the price and the interest are the different sides of the same coin); increase in interest rate (=drop in price) does make this investment (in interest bearing assets) more attractive, but it does not move the demand curve.
However, when we talk about Liquidity Preference Theory, there we mention that an increase in interest rates leads to more demand for interest-bearing assets like bonds.
I am then curious to see the exact terminology was used in your sources.
