Question

answer for part a,b, and c

Draw and label the bond market graph covered in chapter 5. Then, using the graph, illustrate how the equilibrium price, yield to maturity, and quantity changes as a result of:

a. a decrease in expected inflation. Explain the movement from one equilibrium to another.

b. an increase in riskiness of bonds. Explain the movement from one equilibrium to another.

c. an increase in the profitability of business investment. Explain the movement from one equilibrium to another

Answer 1

a. a decrease in expected inflation.

A decrease in expected inflation rate will result in fall in interest rates. Inflation falls with slowdown in the economy. In fact, given that when inflation increases, interest rates rises and the the real cost of borrowing falls, making borrowing cheaper. Therefore, we can say that an decrease in expected inflation causes the supply of bonds to decrease and therefore the supply curve for bonds to shift to the left from S to S1. As Bond price increase, yeild falls. The new equilibrium is point B.

b. an increase in riskiness of bonds.

Risk - while an increase in the riskiness of bonds in respect of other alternative assets, makes bonds less attractive, therefore demand for bonds fall and the demand curve shifts to the left from D to D1. The new equilibrium point is B. As there is inverse relationship between bond price and yield, fall in bond price will result in rise in yield of the bond.

c. an increase in the profitability of business investment.

Expected profitability, which relates to the expectations that firms have about investment opportunities, in fact, when opportunities for profitable plant and equipment investments are plentiful, which usually happens when the business cycle is expanding, firms are more willing to borrow in order to finance their projects. Therefore, the supply of bonds increases, and the supply curve shifts to the right from S to S1. The equilibrium point is B.