Question

1.U.S. govt. budget deficit rose sharply after the financial crisis in 2008, yet interest rate on treasury bonds dropped and stayed low for quite some time. Why?

Answer 1

Government bonds are considered a safe investment. Therefore, in 2008 crisis, at the height of the credit crunch, there was strong demand for government bonds as people looked for security.

These bonds have also been impacted by the Quantitative Easing policy. Fed launched the quantitative easing policy for buying government bonds of billions and trillions of dollars and mortgage backed securities. When the Fed buys these instruments, the money supply in the economy increases. The total amount of currency in circulation with public or held as commercial deposits increased. Commercial banks kept a large portion of this money created as excess reserves with the Fed. Fed even began paying interest to banks for their resrve requirement. Consequently, it became the central bank's primary tool to stop the crisis.

Since, Fed was also buying up these instuments, it automatically created demand for them, which pulled up the price and reduced the yield. Therefore, A new equilibrium rate was reached in the economy that was lower than the previous one.