Question

5 Suppose the government removes tax incentives for investment and spends the additional funds on a new education program. Overall, the changes have no effect on the government's financing requirements. Use the model of supply and demand for bonds to explain the impact of this policy on the equilibrium price of bonds and bond yields.

Answer 1

If there is any case when government removes tax incentives for investment, there would be a case people start investing less in the economy because there are less incentives provided from government end. There exist a negative relationship between investment and interest rates. When investment declines, interest rate increases and vice versa. Refer to the diagram 1.1 below

Assume a case where you but bond worth $1000 at 5% interest rate. Now suppose that interest rate increases to 7%. You as a customer at present time will prefer the bond with higher interest rate because it gives more yield as compared to 5% bond. So if you are expecting 7% interest rate bond instead of 5%, the prices of 5% bonds will likely to fall. So there exist a negative relationship between bond prices and interest rate. refer to the diagram 1.2 above.

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When the price of bonds falls, it demand falls and the supply in market rises which leads to decline in prices at the same quantity of bonds in the market in long run. Equilibrium price come down at P1 from P in long run and quantity in long run remain same at Q. When price falls and interest rate rises, bond yield are bound to fall.

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