Question

Demonstrate graphically and explain in a couple of sentences the effect in the bond market and on interest rates of each of the following:-

           a. decrease in the federal deficit

           b. an increase in personal savings rate

           c. a decrease in the brokerage rates on stock

Answer 1

In each graph, bond price (P) and quantity of bonds (Q) are measured vertically and horizontally respectively. D0 & S0 are initial demand and supply curves of bonds, intersecting at point A within initial price P0 and initial quantity Q0. Since bond price and interest rate are inversely related, the second graph measures bond interest rate (r) and bond price (P) vertically and horizontally respectively, within initial position being point A with initial price P0 (corresponding to intersection of D0 and P0) and initial interest rate r0.

(a) Decrease in federal deficit will lower the demand for borrowing to finance budget deficit. So, supply of government bonds will fall, lowering total supply of bonds, shifting bond supply curve leftward, increasing price and decreasing quantity of bonds. In following graphs, as S0 shifts left to S1, it intersects D0 at point B with higher price P1 and lower quantity Q1. In second graph, the position moves to point B with higher bond price P1 and lower interest rate r1.

(b) Increase in savings rate will increase the demand for such higher interest-bearing asset, decreasing the demand for bonds, shifting bond demand curve leftward, decreasing price and decreasing quantity of bonds. In following graphs, as D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1. In second graph, the position moves to point B with lower bond price P1 and higher interest rate r1.

(c) A decrease in rates on stock brokerage will increase the demand for stock and decrease the demand for bonds, shifting bond demand curve leftward, decreasing price and decreasing quantity of bonds. In following graphs, as D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1. In second graph, the position moves to point B with lower bond price P and higher interest rate r1.