Question

Using both the supply and demand for bonds and liquidity preference framework, show how interest rate are affected when the riskiness of bonds rises. Are the results the same in the two frame works

Answer 1

Answer:

Yes, the results are the same in both frameworks. Please see below for explanation.

Explanation:

With regards to the bond supply and demand framework, people will look to buy more bonds since they are more wealthy now. Hence, the supply of bonds will increase. The supply curve and the demand curve will both move to the right, with the former shifting more than the latter. The equilibrium interest rate will increase.

With regards to the liquidity preference framework, once the economy experiences a positive shift, there will also be an increase in the demand for money. People will make an increased number of transactions as well and hence, the demand curve will move towards the right. The equilibrium interest rate will rise too.