Using appropriate diagrams explain how each of the following events would affect the market for bonds....

Using appropriate diagrams explain how each of the following events would affect the market for bonds. State any assumptions that you make

a deterioration in business conditions that causes a decrease in a nation'swealth.

the expected returnon bonds fallsas compared to other assets.

an increase in the government's borrowing.

an increase in the risk of foreign government bonds.

Expert Solution

In each graph, Price (P) and quantity (Q) of bonds are measured vertically and horizontally respectively. D0 and S0 are initial demand and supply curves intersecting at point A with initial price P0 and initial quantity Q0.

(a) Decrease in nation's wealth will decrease investor income, decrease savings and lowering the demand for bonds. Demand curve will shift leftward, lowering both price and quantity. Since bond price and interest rate are inversely related, lower price will increase interest rate. In following graph, as D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1.

(b) Lower expected return on bonds will make investors invest less in bonds and more in other assets, reducing the demand for bonds. Demand curve will shift leftward, lowering both price and quantity. Since bond price and interest rate are inversely related, lower price will increase interest rate. In following graph, as D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1.

(c) Higher government borrowing will increase budget deficit and government will resort to deficit financing by borrowing via government bonds. Supply of bonds will increase, shifting supply curve rightward, lowering price and raising quantity. Since bond price and interest rate are inversely related, lower price will increase interest rate. In following graph, as S0 shifts rightward to S1, it intersects D0 at point B with lower price P1 and higher quantity of bonds Q1.

(d) Increased risk of foreign government bonds will increase the demand for domestic bonds, shifting the demand curve rightward, increasing both price and quantity. Since bond price and interest rate are inversely related, higher price will decrease interest rate. In following graph, as D0 shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.

Rahul Sunny answered 2 years ago

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