Question

a) What would happen to i if the government were to start running a budget surplus which was used to repay debt/repurchase government bonds? Explain how you know.

b) When the Fed carries out open market purchases with the intent of reducing i it generally buys short-term government bonds (i.e., T-bills). Explain why this will reduce the interest rate on other types of bonds (e.g., corporate bonds) with different maturities even though the Fed didn’t buy those bonds. (Think back to the first days of micro when you learned the supply & demand model.)

Answer 1

a) If the Government were to start a buget surplus to repay debt and repuchase, the i would increase. The more the interests rate the more the citizen will have to pay. And all this would go the corpus of government. this would make the budget surplus. And since it a tool for fiscal policy, any increase in i will increase the budget surplus.

b) when there is open market purchase to reduce i, then fed must increase the t-bills in the economy. When the t-bills increase the then supply is more than demand hence the interest rate declines. Since the supply of t-bills is more , this distorts the bond market and even there i rate decreases indirectly.