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Top-Rated Government Bonds Defy Gravity

11te,,_ r..,..

20

2014

Ralph At!OOs.                             and BenMcUnnohon

'/heft you hil rockbctlOm, lhecnly w•y isup.One day !hat mlgllt apply loyjdds

on  lhe "'odd's Akst  and           liquid govomment bc>ncb-US. Tre.suri<s.

U.K.. gillS. German Bundsand Japaneoe So'"'"""""'bonds.

One day   ll maybe -yet. Ten-year yields on rore gO'emmefI bMds,

y;hich  move inversely ""ith pl'K'es. ha.ve ed,g«I lowtt in 2014-defying • near­ universa) start«'-the-year consensus th.ii the: C)(] y wo1y ""''"up.

German 8und 10-yNT y;ekh this week hll a reeord low ol jusl 1.12 peroent.

Ten-year US.Treasuries yields rose back above 2.S percent on Wednesday on

strong ttenomicdata bul \"Ctt3 perttnt at the 1tart o( 2014.

Such historically meagre rates ""'orry 80mc investors.. tow yields can already translate into negative real interest rates alter taking accou_nt or inflation. (prices

are in bubble territory.a rorrection could inOict heavy capital I on bond

portfolios.

Yields have already risen this year on two--year US. Treasuries and U.K. gilts,

"''hich track closely expectations about centrtl b4nk lntercst rlltc moves.


Among strategists and analysts, it is hard to sense a bubble about to burst, hov.· ·er."For there to be o bubble, there has to be Irrationa l behaviour," s.i.ys Steven Major,glob;ll head ol Rxed lncomc resc•rch ot HSllC.•1don'I sre pooplc boO'Oving  to buy  bonds-aild  l  don't






Economic Analysis


• The MWS article                  lNt the inrates on                   bonds fel

during 2014 &om an ak-..dy low le..i and bond prices ina'e>sed.

•fie.ire I shows d'le: Sitenm me on U.S.                   I 0-,..ar bonds rtom

20IO to mid+2014 (boch the nomiNI me ¥d d-.e rNIrate).

•The wtiig fcatwe ol dis gr;aph is that akhol.gh the intettit rate wu ktirw In 2014.itwas not as IOW' asitfWld beenin 2012. when "-:                                                                                                                        intf!l'ftt  ratewu dose to :ter0for tw0 years andbriefly nepwe at the end of 2012.

•The news ¥Cide says that the &Iii& rato in2014 rislcs            t.he  rult'lt.e

"°"'IM agaln. but thatwould require • ful I .,...._ r.a0n che nominal race or a Ipercencage poin.t rise inthe inflauonnte.

• lhenews           says tNt che intcn!st rate on U.S.&0"10I •!Mef"4 bonds fell from 3 pet' cent to 2..5pe< cent pet"year.Wkh 1"'11.don conmnt ait I .'4 per cent pet' year; d'IC$e numbers tranN:te to a fall "'d'le IUI int.et'e$ rate from 1.6per CMt. toI.Iper cent  per ye:ar.

• fi'gurc 2 tllustnte:S why the real intereSt rate fell.In Janu.uy 201'4, the demand (or loanable funds was OtFJon mdthe su:ppty of toallable funds was StJJllt- The equilibtilA'n Interest rate was 1.6 per cent per year.

• Ovril"lg 20 14.thefactors describedinthe news an.lcle ill'lcrcased the wppfy of

loanable funds to Sl.Jp..

• An Influence on the Interest rate ls mlssJna, from the news article:In 1014.tlc German. U.S.and U.K.. govcmincnt budget cr.cnciu shnii*.wtllch decreased the demand for loanable funds to 01..F}on

• With an increase in supply and a decrease In demand, the cqvl1•brium relJ interest rate fell from 1.6 per cent to I .I per cent per year.


Editing


Questions:

 

a)     When an economic expansion gets going (i.e., an increase in economic activity), what happens to the demand for loanable funds and the interest rate?

b)     Looking at Figure 2, what are the reasons mentioned in the article for the increase in supply of loanable funds to SLFJun?

c)     How does a government budget deficit influence the loanable funds market, and why does a decrease in the deficit lower the interest rate? (Hint: There are two ways to model a government budget deficit: (1) as impacting supply, as discussed in the lecture notes, or (2) as impacting demand, as in Figure 2. You may use either approach. The result on interest rate is the same.)

Looking at Figure 1, what do you think happened to either the demand for or the supply of loanable funds during 2011, 2012 and 2013






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