Question

Answer the following:

a) What five events would shift the supply of bonds to the right?

b) Suppose there is a decrease in expected inflation. Use the bond market model to explain the impact of this event on interest rates.

c) In the previous question (b), the change in interest rates that results from a change in expected inflation is known as.....?

d) In Keynes’s liquidity preference framework, what is the opportunity cost of holding money? Why?

Answer 1

Answer,

A) 1) Expected profitability:

When opportunities for profitable investment are plentiful, which usually happens when the business cycle is expanding. Firms are more willing to borrow in order to finance their project. Therefore the supply of bond increases and the supply curve shift to right...

2) Expected inflation:

When the inflation increase , the real cost of borrowing falls, making borrowing cheaper. Therefore an increase in expected inflation causes the supply of bonds to increase and therefore the supply curve for bond shift to the right...

3) Government budget deficit:

When the government decides to spend more than it earns, therefore to expanding it's budget deficit,it has to increase the supply of bonds in order to finance this excessive spending, the supply curve shift to the right..

4) As business condition improved ,the bond supply curve shift to the right

5) An expansionary fiscal policy will cause the bond supply curve to shift right , which alone decreases bond prices ( increases the interest rate)

B) A decrease in expected inflation raises the demand for bonds and reduces their supply. As a result bond prices increases and the interest rate declines....

C) Fisher effect

D) The opportunity cost of holding money ( Keynes assumed zero return) is higher , as the expectation is that interest rate will be fall , bond price will rise

When interest rates are low, the opportunity cost of holding many is low, and the expectation is that interest rate will rise , decrease the bond price....