Short answer questions1.Decreased budget deficits will reduce the supply of bonds in financial market. Governments usually finance budget deficits by issuing bonds into the market. Therefore,when governments reduce budget deficits, less bonds will be available in the financial market. On the other hand, increased profitability of bonds will increase the demand of bonds. Investors are always looking for the most profitable investment. Therefore, increased profitability will attract more investors. This phenomenon is illustrated in the graph below:If the supply of bonds decreases (the supply curve moves left), bond rates rise (the interest rate falls) and the equilibrium quantity decreases. If demand rises (the demand curve shifts right), prices and volumes rise (and the interest rate falls).
2.The US Federal Reserve makes interest rate decisions based on the state of the economy. The key mechanism used to change interest rates is changing the money supply in the economy through buying and selling federal bonds. If the economists’ forecast comes trueand the US economy goes into recession, the Federal Reserve will be forced to make certain changes. The Fed will purchase bonds from the financial market increasing the money supply in the economy. With excess money, there is excess money for banks to issue loans. To remain competitive and attract borrowers, banks will lower the lower interest rate. As a result, bond prices will increase. This is illustrated in the graph below.3.Expected Inflation Rates