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Use the bond market to predict what will happen to interest rates if the government runs...

Use the bond market to predict what will happen to interest rates if the government runs larger deficits. Use a properly annotated graph in your explanation.

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Answer #1

To finance the deficit, government will issue more bonds. This will increase the supply of bonds, so Bond supply curve will shift rightward, which will decrease bond price and increase the quantity of bonds.

Since bond price and interest rate are inversely related, lower bond price will increase interest rate.

In following graph, D0 and S0 are initial bond demand and supply curves intersecting at point A with initial bond price P0 and quantity of bonds Q0. As bond supply rises, S0 shifts right to S1, intersecting D0 at point B with lower bond price P1 and higher quantity of bonds Q1.

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