Suppose the current annual interest rate on a one-year government bond is 8% and the expected annual interest rate on a one-year bond one year from now is 8.5%, and a one- year bond two years from now is 9%. Based on this information, the current annual interest rate on a three-year government bond is approximately, A. 8.0% 9.0% 8.5% 8.2% 10% ABCDE B. C. D. E.

Bond A pays $8,000 in 28 years. Bond B pays $8,000 in 14 years. (To keep things simple, assume these are zero-coupon bonds, which means the $8,000 is the only payment the bondholder receives.) Suppose the interest rate is 5 percent. Using the rule of 70, the value of Bond A is approximately Now suppose the interest rate increases to 10 percent. Using the rule of 70, the value of Bond A is now approximately I The value of a bond rate. and the value of Bond B is approximately and the value of Bond B is approximately Comparing each bond's value at 5 percent versus 10 percent, Bond A's value decreases by a when the interest rate increases, and bonds with a longer time to maturity are percentage than Bond B's value. sensitive to changes in the interest

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3. Effects of a government budget deficit Consider a hypothetical open economy. The following table presents data on the relationship between various real interest rates and national saving, domestic investment, and net capital outflow in this economy, where the currency is the U.S. dollar. Assume that the economy is currently experiencing a balanced government budget. Real Interest Rate (Percent) 7 National Saving (Billions of dollars) 55 Domestic Investment (Billions of dollars) Net Capital Outflow (Billions of dollars) 30 -15 6 50 40 -10 5 45 50 -5 4 40 60 0 3 35 70 5 2 30 80 10 Given the information in the preceding table, use the blue points (circle symbol) to plot the demand for loanable funds. Next, use the orange points (square symbol) to plot the supply of loanable funds. Finally, use the black point (cross symbol) to indicate the equilibrium in this market. Market for Loanable Funds 10 O Demand 8 O Supply *+ Equilibrium 20 40 80 60 QUANTITY OF LOANABLE FUNDS REAL INTEREST…