In: Economics
Demonstrate graphically the effect an increase in the personal savings rate will have in the bond market. Show and explain the effect of increased savings on bond prices and interest rates. How would this change affect capital spending?
SOLUTION:-
Increase in savings will increse. the demand for bonds in the bond
market. This will shift the demand curve for bonds rightwards from
D to D'. At given supply, S, an increased demand will create a
shortage of bonds in the market. So, price of the bond will start
increasimg. This will incraese the quantity supplied of bounds and
decrease quantity demanded of bonds moving the equilibrium to point
where equilibrium quantity has increased from Q to Q' and
equilibrium price has increased from P to P'.
The price of the bond is inversely related to the interest rate,
so, an increase in price of the bond will lead to decrease in
interest rate in the market and because the equilibrium quantity of
bonds has increased in the market, so, capital spending will also
increase.