Question

Using the bond demand and bond supply and the loanable fund demand and loanable fund supply diagrams, analyse how each of the following event would affect the price of bond and interest rates:

(1) Reduction on corporate taxes on profits due to economic slowdown.

Answer 1

1) when the government reduces corporate taxes demand for loanable funds will increase. So demand curve shift to D1D1 . lt intersects supply curve SS at E1 . As result, interest rate increases from r to r1 and quantity of loanable funds increases from Q to Q1

Now let's look at the bond market, Quantity of bonds is measured along the x axis and price of bonds is measured along the y axis. a reduction in corporate taxes will shift the supply curve of bonds to S1,S1.lntersection of the new supply curve with demand curve lead to an increase in quantity of bonds from Q,to Q1 and reduction in bond prices from P to P1

Therefore its clear that a reduction in taxrates leads to an increase in interest rates and a decline in bond prices.