Describe the connection between the bond market and the money market through the liquidity preference framework.

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Expert Solution

Equilibrium in the bond market simultaneously settles the equilibrium in the money market. This is because the rate of interest determined in the money market is equivalent to the rate of interest determined in the loanable funds market.

Suppose that there is a government budget deficit. This decreases public savings and hence National savings. Government issues bonds to borrow money from the public. In the market for bonds, this is seen as an increase in the supply of bonds. With supply curve shifting to the right, price of bonds falls and quantity demanded and supplied increases.

In the money market, a government budget deficit is likely to increase national income. This increases the demand for money which shifts the demand curve up. Rate of interest is increased but the quantity of money demanded and supplied remains unchanged.

Here we see the connection between the bond market and money market. An increase in the rate of interest reduces the price of bonds and a decline in the rate of interest increases the price of bonds.

Rahul Sunny answered 1 year ago

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