Question

Use the bond market equilibrium to graphically show what will happen to the bond interest rate if the government budget deficit increases. Explain in details.

Answer 1

Ans. An increase in government's budget deficit increases the demand for money (from Md to Md') for given money supply (Ms), people start pulling money from the bond market. This leads to a decrease in demand for bonds (from D to D') which at given supply of bonds (S) leads to a decrease in price of bonds(from P to P') and as price of bonds are inversely related to the interest rate, so, interest rate in the market increases (from r to r')

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