Question

Please treat each separately. Please explain your answer verbally and diagrammatically. Explain what effect(s) a smaller federal deficit might have on interest rates. How has the sudden decrease in people’s expectations of future real estate prices affected interest rates? If the chair of the Federal Reserve has indicated that the Fed will begin to reduce the level of liquidity that it provides to the markets starting before the fourth quarter of this year, what would happen to interest? Please explain. The market for commercial mortgages experiences an October meltdown with significant defaults. How will explain the impact on the interest rates using the bond model?

Answer 1

a) A government incurs a federal deficit when the expenditure is more than the revenue taken from taxes and other non-tax sources excluding debts over a period of time. This gap is covered by borrowing and debts. There are few theories that state that deficits reduce the economic growth of a country by an increase in the interest rate. This increase in the interest rate diverts the private saving from investment to government debt. Economists have discussed about the relationship between federal deficit, interest rate and private investments. Investments have a direct relationship to economic development and national output. The theory assumes that Savings is equal to Investments

S=I

In the case of a federal deficit economy, it will be

S+(T-G)=I

where S is the saving and I is the investment, T is the Tax Revenue, G is the government spending. The equation shows that in a deficit economy, the government spending is more than the tax revenue. This deficit has to be covered by debt which is collected from the institutions and individuals. A portion of the savigs will be taken to fund the government debt, which decreases the investment.

In the above figure, as the government borrows more, the savings function shifts to the left. The gap between the two savings function shows the size of deficit. To conclude, when the federal deficit increases, the interest rates increases and diverts the savings from investment to government debt which is not good for the economy

b) If the Fed chair decides to decrease the level of liquidity ie, tight monetary policy the treasury securities will be sold and increase the reserve requirements at the monetary institutes like banks. this increases the interest rate as the demand for credit has increased. The lenders will  take advntage of this demand. The increased interest rate and Tight monetary policies slows down the economic activities of the nation and can cause recession.

c) Interest rates can affect the property values and the commercial mortgages. The analysis done for bonds and equities  using the income approach can be used for the same. The income approach takes into consideration the net cash flow and Net Operating Income.The changes in interest rate can cause changes in capital flows, demand and supply of a property. When the interests rates increase the mortgages are less affordable.There is an inverse realtionship between interest rates and the mortage affordability.  Rising interest rates could cause the real estate agents to reduce to the price of the houses.