Question

Problem 2 The Behavior of Interest rates (10 points) Suppose the public expects a higher return from holding bonds. Consider the impact of this increase in expected return on the interest rate using the bond demand and supply framework, as well as the liquidity preference framework. First, draw bond demand and supply diagram. Assume, for the sake of your graphs, that we begin in equilibrium. Show the initial equilibrium starting point and the new equilibrium that occurs due to the increase in expected return. Draw and label your graphs carefully showing the effect of the increase in expected return on the interest rate Second, draw liquidity preference diagram. Assume, for the sake of your graphs, that we begin in equilibrium. Show the initial equilibrium starting point and the new equilibrium that occurs due to the increase in expected return. Draw and label your graphs carefully showing the effect of the increase in expected return on the interest rate

Answer 1

(1) Bond market

When investors expect higher return from bonds, they will increase the demand for bonds, shifting bond demand curve to right, increasing both price and quantity of bonds. As bond price and interest rate are negatively related, higher bond price decreases interest rate.

In following graph, D0 and S0 are initial bond demand and supply curves, intersecting at point A with initial price P0 and quantity of bonds Q0. As D0 shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.

90 91 9

(2) Liquidity preference

Higher bond demand will decrease the demand for money. Lower money demand shifts money demand curve to left, decreasing interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. As MD0 shifts left to MD1, it intersects MS0 at point B with lower interest rate r1.

i uso BUDE Mo Mo, MS