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Using demand curve for bonds framework, show and explain how risk and liquidity cause interest rate...

Using demand curve for bonds framework, show and explain how risk and liquidity cause interest rate to shift?

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Answer #1

Please refer to the answer below:


Explanation:

When risk of bonds rises or liquidity of bonds falls then the demand for bonds or loanable funds falls which shifts the demand curve from D0 to D1. As a result at new intersection point the quantity of bonds falls and intetest rate rises from i0 to i1.

In the following figure the interest rate are increasing from up to down.

The reason for rise in the interest rate is that as demand for bonds falls it became less than supply which leads to fall in the price of bonds . Now bonds prices and interest rate are indirectly related to each other thus with fall in the price of bonds the Price of Bonds Interest Rate S Po EO lo P D. Do

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