What is the impact of a business cycle recession on the interest rate? Show graphically using...

What is the impact of a business cycle recession on the interest rate? Show graphically using S and D for bonds and using Liquidity preference framework. How are the results different?

Expert Solution

When there is a recession, income of consumers is reduced. Hence both consumption and savings are reduced. Business also consider investing later as expected returns are reduced. Now on one side reduction in private saving would decrease the supply of bonds and on the other reduced expected returns decreases the demand for bonds. Together these two may or may not change the rate of interest on bonds. However it is observed that the supply shift is smaller than demand shift so that interest rate is decreased and price of bonds is increased

In Liquidity preference framework, reduced income decreases demand for money so that money demand curve shifts down. At the current rate of interest, there is an excess supply of money which implies that there is a downward pressure on the interest to decline. Eventually the money market settles with a lower rate of interest

Hence in both cases, recessions are likely to reduce the rate of interest.

Rahul Sunny answered 1 hour ago

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