Question

1. Using bond market explain how the following events impact the bond prices and the interest rate:

a) A war leads the government to increase spending on the military. (Assume taxes do not change).

b) Someone invents a new kind of computer that makes firms more productive. Many firms want to buy the computer. Higher productivity also increases people’s confidence in the economy, so consumers see less need to save.

c) The economy experiences a business cycle expansion.

d) The expected rate of inflation increases.

e) Wealth in the economy increases at the same time that congress raises the corporate income tax.

Answer 1

a) Increased government deficit will increase the supply of bonds when government issues bonds to finance the deficit arising out of increased spending. This raises the quantity of funds but reduces the interest rate. Bond prices would rise.

b) Savings are reduced and firms demand for investment rises. Hence demand for bonds increases and supply decreases. Interest rate on bonds would increase while bond prices would all.

c) Because of a business cycle expansion, there is increased profitability and higher expected returns so demand for bonds increases and supply increases. Interest rate on bonds and bond price might not change.

d) The expected rate of inflation increases which decreases both demand and supply. Interest rate on bonds and bond price might not change.

e) Wealth in the economy increases which increases demand for bonds so interest rate is increased. At the same time that congress raises the corporate income tax which decreases expected return that decreases demand for bonds so interest rate is decreased. Here also demand increases and decreases so interest rate on bonds and bond price might not change.