QUESTION-1

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

Interest rate (per cent per year) Real interest rate (per cent per year) 4 Uncertainty and Nominal Falling interest weak economic interest rate rate in 2014 2.1- growth increased SLF 3 supply 1.6- Interest Lower government rate fell deficits decreased demand 1.1 Interest rate lowest in 2012 Real interest rate 0 DLF jan 0.6 + DLF -I 2010 201 1 2012 2013 2014 2015 0 2.0 2.5 3.0 3.5 4.0 Year Loanable funds (trillions of 2012/13 dollars) Figure I Interest Rates 2010 to 2014 Figure 2 The Loanable Funds Market in 2014Top-Rated Government Bonds Defy Gravity The Financial Times 20 June 2014 Ralph Atkins, Michael Mackenzie and Ben McLannahan When you hit rock bottom, the only way is up. One day that might apply to yields on the world's safest and most liquid government bonds-U.S. Treasuries, U.K. gilts, German Bunds and Japanese government bonds. One day-but maybe not yet. Ten-year yields on core government bonds, which move inversely with prices, have edged lower in 2014-defying a near- universal start-of-the-year consensus that the only way was up. German Bund 10-year yields this week hit a record low of just 1.12 percent. Ten-year U.S. Treasuries yields rose back above 2.5 percent on Wednesday on strong economic data but were 3 percent at the start of 2014. Such historically meagre rates worry some investors. Low yields can already translate into negative real interest rates after taking account of inflation. If prices are in bubble territory, a correction could inflict heavy capital losses on bond portfolios. Yields have already risen this year on two-year U.S. Treasuries and U.K. gilts, which track closely expectations about central bank interest rate moves. Among strategists and analysts, it is hard to sense a bubble about to burst, however. "For there to be a bubble, there has to be irrational behaviour," says Steven Major, global head of fixed income research at HSBC. "I don't see people borrowing to buy bonds-and I don't think values are far from fundamentals." Essence of the Story Instead, core government bonds offer havens in still-uncertain times- . Interest rates on government Russia's tensions with the west are es- bonds fell during the first half of calating-while yields are held in check 2014. by ultra-loose central bank monetary . The interest rate on German policies and a global glut in savings. .. government bonds were at a "We are unlikely to see U.S. bond record low. yields rise in isolation; we should ex- . U.S. government bonds fell from pect a synchronised move higher once 3 per cent to 2.5 per cent during the global economy is fully recovering," the first half of 2014. says Zach Pandl, portfolio manager at . Real interest rates could become Columbia Management. negative. Financial Times, 2014. . When interest rates rise, bond prices will fall. Economic Analysis The news article reports that the interest rates on government bonds fell during 2014 from an already low level and bond prices increased. Figure I shows the interest rate on U.S. government 10-year bonds from 2010 to mid-2014 (both the nominal rate and the real rate). The striking feature of this graph is that although the interest rate was low in 2014, it was not as low as it had been in 2012, when the real interest rate was close to zero for two years and briefly negative at the end of 2012. . The news article says that the falling rate in 2014 risks making the real rate negative again, but that would require a full I percentage fall in the nominal interest rate or a | percentage point rise in the inflation rate. . The news article says that the interest rate on U.S. government bonds fell from 3 per cent to 2.5 per cent per year. With inflation constant at 1.4 per cent per year, these numbers translate to a fall in the real interest rate from 1.6 per cent to I. I per cent per year. Figure 2 illustrates why the real interest rate fell. In January 2014, the demand for loanable funds was DLFjon and the supply of loanable funds was SUFjan- The equilibrium interest rate was 1.6 per cent per year. . During 2014, the factors described in the news article increased the supply of loanable funds to SLFjun- . An influence on the interest rate is missing from the news article: In 2014, the German, U.S. and U.K. government budget deficits shrank, which decreased the demand for loanable funds to DLF jun- With an increase in supply and a decrease in demand, the equilibrium real interest rate fell from 1.6 per cent to I. I per cent per year