Question

Assume a sharp increase in government deficit occurs and it is financed by issuing new bonds. Using the supply and demand in the bond market model, what would be the resulting effect on the interest rate? Explain your answer.

Your explanation shall at least include the following: (i) specify whether this shock refers to shifter/determinant of the demand curve or the supply curve, (ii) what happens to such curve, (iii) what is the impact on the market equilibrium--whether it remains the same or changes--, and (iv) what the effect is on the interest rate.

Answer 1

Following figure shows the Bonds Market -

Initially, the market for bonds was in equilibrium at point E1, where, demand curve for bonds, D1, was intersecting the supply curve of bonds, S1. The equilibrium interest rate was r1 and the equilibrium quantity of bonds traded is Q1.

Now, it has been stated that a sharp increase in government deficit has occurred. In order to finance this deficit, government has issued new bonds.

This issue of new bonds will increase the supply of bonds. This increase in supply will shift the supply curve of bond. The supply curve of bond wil shift to the right from S1 to S2.

New equilibrium is attained at point E2, where demand curve, D1, is intersecting the new supply curve, S2.

The new equilibrium interest rate is r2 and new equilibrium quantity of bonds traded is Q2.

Thus, market equilibrium has moved downwards from E1 to E2 and interest rate has decreased from r1 to r2.