Question

Use the bond market equilibrium to graphically show what will happen to the bond interest rate if the citizens in a country suddenly becomes wealthy because of discovering a new gold mine. Explain in details.

Answer 1

It has been provided that citizen of the country has suddenly becomes welathy due to discovery of a new gold mine.

This discovery and resulting wealth will increase the propensity to invest of the people in the country.

Since, bonds are less risky and offer higher return, people would be induced to invest in these due to newly acquired wealth.

This will result in an increase in demand for bonds.

Due to this, demand curve for bonds will shift to the right.

Following is the required figure -

Initially, the bond market was in equilibrium at point E, where, demand curve for bonds, D, was intersecting the supply curve of bonds, S.

The equilibrium price was P and the equilibrium quantity was Q.

Now, the demand for bonds has increased due to increase in wealth in the country.

This will shift the demand curve for bonds to the right from D to D1.

New equilibrium is attained at point E1, where, new demand curve, D1, is intersecting the supply curve, S.

The new equilibrium price is P1 and the new equilibrium quantity is Q1.

Thus, the price of bonds in the bond market has increased.

There exists an inverse relationship between price of bonds and interest rate.

So, this increase in price of bonds will result in a decrease in interest rate.

Thus,

The bond interest rate will fall.