Question

From the Portfolio Choice Theory: Consider an economy that is undergoing a recession. Using and drawing the demand and supply of bonds, show and explain what happens.

Answer 1

During a recession, there are less profitable opportunities for the businesses. This is because a recession slows down the economic activity. This results in businesses borrowing lesser and hence the supply of bonds will shift to the left.

During recession, incomes of individuals decline due to which they demand lesser bonds because of their decreased capacity to lend.(As far as the demand for bonds is concerned, the demand for government bonds is likely to rise since it is a safer tool of investment. However, the demand for only those bonds will decline which are riskier. This is because during recession, investors become risk averse.)

Thus, the demand curve will shift leftwards.

Now, the point where demand and supply curves intersect, the interest rate is determined. If the magnitude of decline in the demand and supply of bonds is the same, equilibrium interest rate remains the same. However, equilibrium quantity will decline.

Now, the interest rates and yields move in the opposite direction in the economy. The rise in the interest rates implies lower yields. In this case, the yields will remain the same.

We can make three cases wih different magnitudes of change in the supply and demand as is shown in the diagram.