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Use the bond market equilibrium to graphically show what will happen to the bond interest rate...

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.

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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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