Question

Suppose a country with a struggling economy suddenly discovered vast quantities of valuable minerals under government-owned land. How might the government’s bond rating be affected? Using the model of demand and supply for bonds, what would you expect to happen to the bond yields of that country’s government bonds?

A) The bonds of that government would likely be upgraded, as the economic outlook for the economy would improve and the reduction in the perceived riskiness of the bonds would shift the demand curve to the right. Revenues from the minerals could also mitigate the government’s need to borrow, shifting the supply of bonds to the left. Bond yields would rise and bond prices would fall.

B) The bonds of that government would likely be upgraded, as the economic outlook for the economy would improve and the reduction in the perceived riskiness of the bonds would shift the demand curve to the right. Revenues from the minerals could also mitigate the government’s need to borrow, shifting the supply of bonds to the left. Bond prices would increase and bond yields would fall.

C) The bonds of that government would likely be upgraded. As the bonds have a higher rating, you should expect bond yields to rise due to increased demand.

D) You would not expect the government bond rating to be affected, as it is determined solely by other factors. The supply and demand curves will not shift and there would be no change in the bond yields.

Answer 1

Correct option is (B).

A perceived improvement in economic outlook will increase investor confidence in the country, increasing demand for government bonds. At the same time, government revenues out of the new mineral stock will increase, which will reduce budget deficit ceteris paribus, lowering the need for borrowing, so government will issue (sell) less number of bonds, shifting bond supply curve leftward. Both a rightward shift in demand curve and leftward shift in supply curve will increase bond price. Since bond price is inversely related to bond yield, higher bond price will lower bond yield.