After you have studied Economics in the News on pp. 174–175, answer the followin
ID: 1209761 • Letter: A
Question
After you have studied Economics in the News on pp. 174–175, answer the following questions.
Link to article - www.ft.com/intl/cms/s/0/799f548e-1716-11e4-8617-00144feabdc0.html#axzz47hnctx6O
After you have studied Economics in the News on pp. 174–175, answer the following questions.
a. Why does the news article say that bond prices and interest rates move in opposite directions? Is it correct? Explain.
b. How does a government budget deficit influence the loanable funds market and why does a decrease in the deficit lower the real interest rate?
c. When an economic expansion gets going, what happens to the demand for loanable funds and the real interest rate?
d. If an expanding economy increases government tax revenue, how will that affect the loanable funds market and the real interest rate?
e. Looking at Fig. 1 on p. 175, what must have happened to either the demand for or the supply of loanable funds during 2011, 2012, and 2013?
Explanation / Answer
1) Yes, it is true that there is an inverse relation between the price of a bond and interest rate. For example, the price of zero-coupon a bond is $1000 with an interest of 5.5%. Now, if current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.5% would not only be less attractive, it wouldn't be in demand at all.
To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $1000 (which gives a 5.5% yield) to $950 (which gives a 10% yield).This shows how a bond's price moves in relation to interest-rate changes,
2) When a government runs a deficit, it must borrow money to pay for its debt and people buy these bonds with their personal savings. This causes the supply of loanable funds (savings curve) to decrease and causes a shift left in the curve. The leftward shift creates a new equilibrium point at a higher interest rate.
The crowding out effect occurs when a government runs a budget deficit (it spends more money than it collects), causing the real interest rate to increase, and private investment to decrease because it becomes “crowded out."
In addition, increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has "crowded out" investment.