Question

Suppose that the U.S. government significantly increases its budget deficit and finances the resulting debt by selling government bonds to Canadians. What would be the impact of this action on the bond markets

Suppose that the U.S. government significantly increases its budget deficit and finances the resulting debt by selling government bonds to Canadians. What would be the impact of this action on the bond markets.

Answer 1

s Supply Supply, Eu Rate of interest < E , Demanda QEQI Loanable funda

As this can be seen from the above diagram.

In the loanable fund market E1 is the equilibrium where R1 is the rate of interest and Q1 is the loanable funds available for supply.

As Canadian government budget deficit increased and deficit financing happened by domestic debt, this will reduce the supply of loanable funds in the market because now that money is borrowed by the government, therefore Q1 reduced to Q2. This will result in rise in interest rate from R1 to R2, shifting the equilibrium from E1 to E2. Therefore we can say that deficit financing will cause the interest rate to rise.

When interest rate rise bond prices fall (because of the inverse relation between bond yields and their price). Therefore bond market will fall as a result of this action.

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