Question

The business cycle refers to the up (expansion) and down (recession) of economic activity over time as measured by real GDP. Briefly, explain how these ups and downs affect the following variables. Show your understanding of how each of these variables move when there is a recession and again when there is economic expansion. Pay attention to what is happening to these variables during this present recession. In addition, a sentence or two explaining why it moves that way.

- General level of interest rates

- Real interest rates

- Yield Curves

- Stock prices

- Bond prices

- Inflation

Answer 1

Answer - Business cycle refers to the growth /expansion and recession/ contraction in economy measured by Real GDP or national income. This business cycle affects various economic variables like, general level of interest rates, Real interest rates, Yield Curves, Stock prices, Bond prices, Inflation etc.

Business cycles are comprised of cyclical upswings and downswings in the economic activities i.e. —output, employment, income, and sales etc. These ups and downs consequently affect economic variables.

1. General level of Interest rates -

In the recession, there is a decrease in demand for liquidity in general public, and the normal expectation would be for interest rates to fall as the recession approaches. Therefore general level of Loanable interest rate for availing a loan usually decreases in recession due to excessive liquid cash in economy not deployed in productive resources. During a depression, central bank prefers to lower the repo rate leading to low interest rates which encourages borrowing and spending ultimately resulting in stimulating the economy.

On the contrary, in boom, there is excessive demand for liquid cash or working capital in economy and level of interest rates are usually high for loanable funds when there is an expansion.

2. Yield Curves -

The Yield Curve is a graphical presentation of the interest rates on debt for a range of maturities. It shows the yield an investor is expecting to earn if he lends his money over a given period of time.

The graph displays a bond’s yield on the vertical axis and the time to maturity across the horizontal axis. The curve takes different shapes at different phases in the economic cycle, but it is generally upward sloping.

Inverted Yield Curve in Recession -

During the recession, investors expect falling short-term interest rates in the future, leads to a decrease in long term yields and an increase in short term yields in the present, causing the yield curve to flatten or even invert. An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. When a yield curve inverts, investors have little confidence in the near-term economy and they demand more yield for a short-term investment than for a long-term as they perceive the near-term as riskier than the distant future.

Steep Yield Curve in Expansion-

This type of curve can be seen at the beginning of an economic expansion (or after the end of a recession) whereby the interest rates paid on securities with shorter maturities is lower than rates paid on debt with longer maturities.

3. Real Interest Rates -

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. Real interest rates are determined by the levels of saving and fixed investment in the economy.

In recession, fixed investment decreases as public try to save more instead of investing or spending, therefore a decrease in the real interest rate occurs. On the contrary, in expansion an increase in the real interest rate occurs if saving decreases or fixed investment increases.

4. Stock prices

In Generally, Stock / Shares prices tumbles during a recession as people spend and invest less during a recession. Many companies suffer a loss of revenue and profits in the short term which reflects on the market prices of shares. Further share prices are driven by investors' expectations for future earnings. In recession investors think the recovery will be much slower, and shares fall that much further.

The opposite of above happens in expansion / growth / boom where people spend and invest more. People are optimistic about future growth and prospects and there is enough flow of money in the market, resultantly share prices keep on increasing

5. Bond Prices

During the expansion there is an increase in the money supply, and consequently bond prices will increase. In recession, due to decrease in the money supply, bond prices will decrease.

During recession, the prices of risky bonds go down as people sell them, and the yields on these bonds increase. The prices of Treasury bonds go up, meaning their yields decrease.

6. Inflation

During the recession, there is a lot of pessimism in economy. Overall growth, earnings, employment and income are decreased. Therefore, price levels of goods and services are decreased and inflation is not present in economy

On the contrary, in growth / boom, overall growth, earnings, employment and income are increased. Therefore, price levels of goods and services are increased. The inflation and expansion are positively correlated and the recession and inflation are negatively related.