Question

Evidence shows that interest rates are procyclical (interest rates rise during economic expansions, and fall during economic contractions). Explain the statement above using either the S & D for Bonds or the S & D for Credit model in your answer, showing (you need to provide a drawing or graph with the axes properly labeled and equilibrium identified) what happens to the price of bonds, the quantity of bonds and interest rates both during an expansion and during a contraction.

Answer 1

During the economic expansion, household income is increased and become much wealthier than before. Hence, household is looking for attractive investment opportunities. So, demand curve for bond is moved to Bd1 from Bd2.

Hence, interest rate of bonds are increased.

Looking to the increased demand, quantity (supply) of bonds is also increased in market. Supply of bonds is moved from Bs1 to Bs2. But, supply curve shifts more than the demand curve. This will cause reduction in bond price. Equilibrium is attained in point 1 when demand and supply are equally met.

During the economic contraction, household income and wealth are reduced. Hence, demand for bond is also reduced as household is lesser looking for investment opportunities. So, demand curve for bond is moved to Bd2 from Bd1. Bonds interest rates falls.

Looking to the reduced demand, quantity (supply) of bonds is also reduced in market. .Supply of bonds is moved from Bs2 to Bs1. But, supply curve shifts more than the demand curve. This will cause increase in bond price. This will cause reduction in bond price. Equilibrium is attained in point 1 when demand and supply are equally met.