Question

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?

Answer 1

Ans. Increase in savings will increase 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 increasing. This will increase the quantity supplied of bonds 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.