Question

1. What factors might increase the demand for bonds? The supply?

4. One journalist writing about the complex interactions between various markets in the economy stated: “When the government spends more than it takes in taxes it must sell bonds to finance its excess expenditures. But selling bonds drives interest rates down and thus stimulates the economy by encouraging more investment and decreasing the foreign exchange rate, which helps our export industries.” Carefully analyze the statement. Do you agree? Why or why not?

5. What do you predict will happen to the foreign exchange rate if interest rates in the United States increase dramatically over the next year? Explain, using a graph of the foreign exchange market. How would such a change affect real GDP and the price level?

6. Suppose the government were to increase its purchases, issuing bonds to finance these purchases. Use your knowledge of the bond and foreign exchange markets to explain how this would affect investment and net exports.

Answer 1

1.

There are different factors that help in increase the demand for the bonds. The first factor is the increase in income that makes people to invest their savings in the bonds. It causes the demand to increase. The second factor is the relative level of risk & volatility of the bonds. If the stock investments become more risky and volatile, then people demand more for the bonds. The third factor is the expectation in the decrease of interest rates. With this expectation, demand for the bond increases as after some time, the interest rates will decrease and the value of the bond will increase to give better return. The fourth factor is the expectation of decrease in inflation rate. It will cause the demand for the bond to increase.
The first factor is the booming or an improved level of economic scenario that cause the supply of the bonds to increase in the market. The second factor is the expectation of increase in the inflation. It will cause the company to pay relatively less real value of coupon payments to the investors. So, it will benefit the companies and more quantity of the bonds will be supplied in the market. Government also issues bonds when there is a budget deficit. So, the deficit in budget is also a factor that drives the supply of bond to increase.

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