Question

4.a. Suppose that the nominal interest rate is 6%. If the nominal rate is three times of the real interest rate. Find the inflation rate?

b.If both riskiness of bonds and government budget deficit increase, what would happen to bonds prices? Show these changes in a graph?

Answer 1

(a)

Nominal rate = 3 x Real rate

Real rate = Nominal rate / 3 = 6%/3 = 2%

Inflation rate = Nominal rate - Real rate

= 6% - 2%

= 4%

(b)

Higher riskiness will decrease bond demand, shifting demand curve leftward,decreasing both price and quantity. A budget deficit will increase bond supply (for deficit financing) which will shift supply curve rightward, decreasing price and increasing quantity.

The net effect is a definite decrease in price. But quantity may increase, decrease or stay the same.

In the graphs, D0 and S0 are initial demand and supply curves of bond, intersecting at point A with equilibrium price P0 and quantity Q0.

(I) Leftward shift in demand is more than the rightward shift in supply: Quantity decreases

In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower price P1 and lower quantity Q1.

(II) Leftward shift in demand is less than the rightward shift in supply: Quantity increases

In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower price P1 and higher quantity Q1.

(III) Leftward shift in demand is equal to the rightward shift in supply: Quantity unchanged

In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower price P1 and same quantity Q0.