What effect a large federal deficit have on interest rates


Questions:

1. Explain what effect a large federal deficit should have on interest rates.

2. Predict what will happen to interest rates if prices in the bond market become more volatile .

3.The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.

4. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.

5. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed?

6. An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?

7. Using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are procyclical, rising when the economy is expanding.

8. Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?

9. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations:

Bd: Price = - 0.6 * Quantity + 1140; Bs: Price = Quantity + 700

a. What is the expected equilibrium price and quantity of bonds in this market? Solve for equilibrium (Bd = Bs) (200, 275, 300) (857, 933, 975)

b. Given your answer to part (a), what is the expected interest rate in this market? (2.56, 2.88, 3.0)

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