Full Question:
Moldavia, an open economy currently in long-run macroeconomic equilibrium, has become concerned about its debt levels and the effects those levels might have on its international financial position. The Moldavian parliament decides to implement austerity measures to bring those debt levels down.
Suppose the country cuts government spending to reduce its deficit, and this policy reduces the risk premium on Moldavian assets. Economists also note that in the new long-run equilibrium, the quantity of national savings stays the same.
Questions:
I) Why might holders of Moldavian government bonds see the value of their portfolios rise as a result of this austerity measure policy and its effects. Identify and explain two reasons for this rise in value, and make reference to Moldavian government bond prices in your answers.
II.) The reduction in the Moldavian budget deficit means ________ new bonds are floated to the bond market, thus _______ bond prices.
A. Fewer ; decreasing
B. More ; decreasing
C. More ; increasing
D. Fewer ; increasing
Answer:
Austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. Austerity measures are used by governments that find it difficult to pay their debts.
I) Holders of Modavian government bonds will see the value of their portfolios rise as a result fo this austerity because an the part of the austerity measures which the government will put in place will include cutting down on government spending. Fiscal retrenchment could be presented as urgently needed to avert a Greek-style strike by bond buyers. “Greece stands as a warning of what happens to countries that lose their credibility, or whose governments pretend that difficult decisions can somehow be avoided.
When government takes this stance, even though the economy is is a bad state, this move by the government gives off a positive outlook to holders of bonds.
Secondly, when government intervenes to salvage the economy, usually it translates into a positive outlook which in turn give rise to the value of existing bonds.
II) The answer is D) Fewer; Increasing.
That is the reduction in the Moldavian budget deficit means fewer new bonds are floated to the bond market, thus increasing bond prices.
Step-by-step explanation:
When government spends, inflation expectations rises, interest rates rises, so the discount rate used to calculate the bond's price increases, and the bond's price falls.
The opposite would occur when inflation expectations fall.
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