Question

Suppose that the bond market begins in equilibrium. Suppose also that the U.S. government decides to invest more money into NASA, increasing the budget deficit. What is the effect of this action on equilibrium interest rates and bond prices? Use the bond market to show this.

Answer 1

A budget deficit or fiscal deficit is the annual shortfall between government spending and tax revenue. The deficit is the annual amount the government need to borrow. The deficit is primarily funded by selling government bonds to the private sector.

U.S. government's decision to invest more money into NASA will increase the budget deficit.

Following are the effect of this action on equilibrium interest rates and bond prices.

Effect on Interest Rate

When the government borrows, it offers to pay an interest payment to those who buy the bonds. The interest rate attracts investors to lend the government money. Now, as government needs to borrow from the private sector, there would be less loanable funds available in the market than before ( that is at equilibrium level ). This will put pressure on interest rate and thus interest rates would rise to reach at an equilibrium level.

Effect on bond price.

Bond price is the present discounted value of future cash stream generated by a bond. It refers to the sum of the present values of all likely coupon payments plus the present value of the par value at maturity. Now, more the borrowing by the governmnent, higher will be the bond prices.