Why do bond prices decrease when interest rates rise, and vice versa?

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    Interest rates are increased in order to reduce liquidity in the economy and it is increased so that liquidity may be decreased in the economy.It happens like this – when people find that the interest rates have been increased they tend to deposit money in the banks and not keep keep it with themselves as they find the interest rates attractive.They also tend not to take loans from the banks because the interest they will need to pay shall be relatively higher.Thus, the increase in interest rates decrease liquidity in the economy….and opposite happens for reduced interest rates.

    The prices of the Bonds are decreased to reduce the liquidity in the economy and it is increased to reduce the liquidity.It happens like this – When public find that the prices of the bonds are low they tend to buy the bonds and hence parting from their money thus reducing liquidity.Opposite happens for increase in bond prices….the public tends to sell the bonds they possess thus acquiring money and increasing liquidity.

    As we can see from the above explanations that decrease in bond prices and rise in the interest rates both target the same aim i.e, reduction in liquidity so we find both of them simultaneously in the economy.

    I hope the answer satisfies you….

    Answered by: Ritika on Dec 17, 2010 Reply

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