According to an article in the Wall Street Journal in early 2016: U.S. government bonds maturing in more than 25 years returned a negative 1.2% in the month through Thursday … after chalking up a 8.7% gain between January and March…. The reversal reflects a shift in financial markets’ preoccupation from the prospect of a recession to the risk of higher inflation.
a. Why would bond prices fall if investors believe that inflation will be higher than they had previously expected? Illustrate your answer with a graph showing demand and supply for bonds.
b. In this situation, would bonds that mature in 25 years be likely to have experienced larger or smaller price declines than bonds that mature in two years? Briefly explain.