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In a closed economy, how would each of the following events affect bond price and market...

In a closed economy, how would each of the following events affect bond price and market interest rate? Use the figures of both bond market and market of loanable funds to illustrate the changes to the interest rates.

  1. The expected rate of inflation decreases.
  2. The federal government runs a budget deficit.
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Answer #1

1) Fall in expected inflation will shift the demand curve to the right in the bond market while it shifts the supply curve to the right. This implies that bond prices are likely to fall and in the loanable funds market interest rate will increase. This happens as demand for loanable funds will increase.

Price Supply SS SS PO ---- Pif--- ------- Demand DD DD Quantity

Interest rate r2 >EOL DD DD L L2 Loanable funds (L)

2) Since there is a budget deficit, government will issue bonds so supply curve in bond market shifts right. Price of bonds decline and quantity increases. In loanable funds market, demand for funds increases and this raises the rate of interest.

Effect of an increase in supply Price($) Supply curve SS PO -- - - - - - - - - - - - - - - - Demand curve DD - - - QO Q1 Quan

Interest rate r2 >EOL DD DD L L2 Loanable funds (L)

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