Question

The demand curve and supply curve for one-year discount bonds were estimated using the following equations:

B^d : Price = -0.4 Quantity + 940

B^s : Price = Quantity + 500

Following a dramatic increase in the value of the stock market, many retirees started moving money out of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, such that the price of bonds at all quantities increased $50. Assuming no change in the supply equation for bonds, what is the new equilibrium price and quantity? What is the new market interest rate?

Answer 1

i)New equilibrium price and quantity is calculated as follows,

Bd : Price = -0.4 Quantity + 990

Bs : Price = Quantity + 500

Bd : Price = Bs : Price

-0.4 Quantity + 990= Quantity + 500

1 Quantity+0.4 Quantity = 990-500

1.4 Quantity =490

Therefore, Quantity = 490/1.4

Quantity = 350

Bs : Price = Quantity + 500

Bs : Price = 350 + 500

Bs : Price = 850

ii)New market interest rate is calculated as follows,

New market interest rate = (F-P)/P

Where,

F means Face value of discount bond

P means initial purchase price of discount bond

New market interest rate = (F-P)/P

New market interest rate = (1000-850)/850

New market interest rate = 0.1765 i.e., 17.65%