Question 8 (a) What effects would an increase in government deficit have on the price of...

Question 8 (a) What effects would an increase in government deficit have on the price of securities? (b) What effect would a decrease in the money supply have on the price of securities? Draw the appropriate graphs and explain.

Expert Solution

Part 1) An increase in the government deficit decreases the price of securities. This is because increase in government deficit means that government has increased its expenditure. Increase in government expenditure raises the level of income in the economy. For a given level of money supply, an increase in the level of income raises the transaction demand for money in the economy. People will now start to withdraw money from their speculative balances to finance their transaction needs. To keep the money market in equilibrium the interest rate will rise while the price of securities will decline.

As shown in the diagram below the increase in government expenditure causes the IS curve to shift from IS₁ to IS₂. The interest rate rises along the LM curve to keep the money market in equilibrium from r₁ to r₂.

Part 2) A decrease in the money supply will cause the price of securities to decline. This is because, for a given level of income, a decrease in the level of money supply raises the transaction demand for money in the economy. People will now start to withdraw money from their speculative balances to finance their transaction needs. To keep the money market in equilibrium the interest rate will rise while the price of securities will decline.

As shown in the diagram below decrease in money supply causes the LM curve to shift from LM₁ to LM₂. The interest rate rises along the LM curve to keep the money market in equilibrium from r₁ to r₂.

Rahul Sunny answered 2 years ago

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