Question

Assume a sharp increase in government deficit occurs and it is financed by issuing new bonds. Using the supply and demand in the bond market model, what would be the resulting effect on the interest rate? Explain.

Explanation shall include the following: 1. specify whether this shock refers to shifter/determinant of the demand curve or the supply curve, 2 what happens to such curve , 3 what is the impact on the market equilibrium whether it remains the same or changes and 4 what the effect is on the interest rate.

Answer 1

In the market for bonds, government has issued bonds to cover its deficit. We know that the supply of bonds is increased when there is an increased government budget deficit. Hence the supply of bonds increases and the supply curve shifts to the right.

This results in creating a surplus at the current bond prices which forces suppliers of bonds to offer a lower bond price. Price of bond falls and there is an increase in the quantity of bonds supplied. Hence market shifts to a new equilibrium with lower price and higher quantity

Now bond price and rate of interest are inversely related. Hence when bond price fall, the rate of interest increases.