Show why interest rates decrease when the economy falls into a recession. Use both the market...

Show why interest rates decrease when the economy falls into a recession. Use both the market for money and the market for bonds to show your answer. Make sure to label all elements on your graphs and clearly indicate all shifts and their directions.

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Expert Solution

(a) During recession, income decreases and so, demand for money falls, shifting money demand curve leftward which lowers both interest rate and quantity of money. In following graph, MD0 & MS0 are initial money demand & money supply curves intersecting at point A with initial real interest rate r0 and quantity of money M0. As demand curve shifts left to MD1, it intersects MS0 at point B, lowering real interest rate to r1.

(b) During recession, firms lower output and issues less bonds for financing their expansion plans, which decreases supply of bonds, shifting bond supply curve leftward which increases bond price and decreases the quantity of bonds. Since bond price and interest rates are inversely related, higher bond price lowers interest rate. In following graph, D0 & S0 are initial demand & supply curves for bonds, intersecting at point A with initial bond price P0 and quantity of bonds Q0. As supply curve shifts right to S1, it intersects D0 at point B, increasing price to P1 and decreasing quantity to Q1.

Rahul Sunny answered 1 year ago

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