Question

Please explain how an increase in the profitability of investments paired with decreased deficits affects bond prices and interest rates. Use graph(s) to show this

Answer 1

Greetings for the day,

First of all, we will understand what a deficit is and how they affect the investment return or bond yield:

It doesn't need to always affect the bond yield. It depends upon the stability of a country’s economy.

1. If the fiscal deficit is very high and Government wants to finance it through issuing bonds, then the public may fear the economy has become fragile and there is a risk that Government may default on it. So they are not interested in buying and they rather prefer to sell. Investors will demand more return due to the risk factor. So in this case the bond yield will increase.

2. If the deficit is too high and Government has no other way to finance it other than the bond issue, then public and investors will always demand a high yield as they will be sceptical that Government could print more money to pay their bond interest which ultimately raises inflation and their bond will lose its value.

But if a country’s economy is too strong to handle the debt and investors have full faith in the economy like the USA, UK, Japan, then bond yield rarely increases.

Now we can see our condition in a graph to get a better understanding of the scenario:

As we can see in our graph the supply demanded is being increased from Q for Q1 due to the given reason that is the deficit, but the things that need to be focused here is that the purchase price shift downward and reduced from $95 to $93 and the interest earned on bond increased from 5% to 7%.

So we can say that in the case of decreased deficit affects the investors are getting benefitted with an increase in the rate of return at a decreased price. As the US governments issue new bonds to finance its $1.8 trillion budget deficit, the supply of US bonds increases, lowering the prices. Since the face value of US bond is fixed, a lower price equates to higher interest rates.

Quantity demanded of bond increases, as the public and commercial bank direct their savings out of the private sector and into the market of the US government.