Question

1) How do fiscal and monetary policy affect interest rates in our economy?

2) Why do interest rates affect bond prices? Explain.

Answer 1

1) Fiscal and monetary policies have a huge impact on the interest rate.

The Fed conducts the monetary policy to target a moderate inflation rate, low unemployment and stable economic growth. The Fed achieves these objectives by controlling the money supply. When the Fed reduces the money supply, the supply of loanable funds decline with respect to the demand; so, the interest rate goes up. On the other hand, when the Fed increases the money supply, the supply of loanable funds goes up with respect to the demand; so, the interest rate goes down.

The government conducts expansionary fiscal policy(in which the government expenses are increased and/or taxes are reduced) or contractionary fiscal policy (in which the government expenses are decreased and/or taxes are increased). When the government conducts expansionary fiscal policy, it borrows funds. Government borrowing reduces the among of loanable funds for the public, which raises the interest rate. On the other hand, when the government reduces borrowing in the case of contractionary fiscal policy, which pushes the interest rate up.