Question

2. 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.

a. The economy experiences a business cycle expansion.

b. The government proposes a new tax on consumption (spending on goods and services).

Answer 1

a A busine to finance demand expansion will increase the supply ns because overall production increases and finance it, firms supply bonds. It also increases and for loanable funds in the loanable fund arket shifting the Irimest ment curve right wards. tanable funds market " Bond market Price к 7 rate д-, в 1 Interest Bd 7x decu ų da Bond This SLI SLI shows X decrease that business cycle expansion in leads to price of bonds ease in bond market and increase rate in of interest in toanable fund market. 6 Tax on consumption will increase sanings of individu- als. As sanings increases demand for bonds will increase and supply of loanable funds or saning increase in the loanable fond market. This can be depicted as a i Bond market s W Loanable fund market Y. rate briceat 5 + XE Interest 1 Quantity Quantity o f SLI SEI X All Innestment Thus srice a of a l tax on bonds consumption and decrease leads to in the increase in rate of interest