Question

In: Economics

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.

Solutions

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
Next > < Previous

Related Solutions

Why do interest rates decrease when the economy falls into a recession? Use both the market...
Why do 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.
Using the appropriate supply and demand diagrams, show why market interest rates are rising when the...
Using the appropriate supply and demand diagrams, show why market interest rates are rising when the economy is expanding.
1) When aggregate price level in the economy falls, then the interest rate in the economy...
1) When aggregate price level in the economy falls, then the interest rate in the economy falls, which leads to an increase in investment expenditure in the economy. This phenomenon is called: A) the wealth effect B) the interest rate effect C) the exchange rate effect D) the investment effect 2)The Quantity Theory of Money can be used to explain why: A) SRAS curve is downward sloping B) SRAS curve is upward sloping C) AD curve is downward sloping, AD...
When the economy is in recession, government revenue falls due to a falling tax base. Therefore...
When the economy is in recession, government revenue falls due to a falling tax base. Therefore the proper role of government should be to increase taxes and cut spending so as to balance the Federal budget. Do you agree? Why? “Money not backed by gold or silver is worthless paper and is a fraud committed against the people of the United States.” Critically evaluate this statement.
When the economy is in recession, government revenue falls due to a falling tax base. Therefore...
When the economy is in recession, government revenue falls due to a falling tax base. Therefore the proper role of government should be to increase taxes and cut spending so as to balance the Federal budget. Do you agree? Why? “Money not backed by gold or silver is worthless paper and is a fraud committed against the people of the United States.” Critically evaluate this statement.
Assume that the economy falls into recession. (i.e., output falls below full employment output) and the...
Assume that the economy falls into recession. (i.e., output falls below full employment output) and the Fed describes by buying bonds. Briefly describe the process by which the money supply is affected? What does this do to the Interest rate? Briefly explain the chain of causality of how monetary policy might help affect help move the economy back toward full employment output (That is, how can monetary policy affect AD in the short-run?) Discuss the factors or circumstances that may...
The next time the economy falls into a recession, there will be a spirited debate about...
The next time the economy falls into a recession, there will be a spirited debate about whether the government should try to counteract the downturn, or whether it is better to let the economy run its course. Most likely, there will some action taken to try to improve the economy. Then the debate will turn to what tools the government should use to fight the recession. In this week's discussion we will focus on (1) what role the government should...
Why is it difficult for a company to raise capital when the economy is in recession?
Why is it difficult for a company to raise capital when the economy is in recession?
5. Explain the economic impact of a decrease in interest rates. Be sure use the concept...
5. Explain the economic impact of a decrease in interest rates. Be sure use the concept taught in the course in your explanation. 6. What is the short-run trade-off in the response to a short-term supply shock? Why is this trade-off unavoidable?
A Bank’s Chief Economist is forecasting a substantial decrease in money market interest rates over the...
A Bank’s Chief Economist is forecasting a substantial decrease in money market interest rates over the next 4 weeks. Assuming the Chief Economist is correct in her forecast, what would you recommend to Harris Bank’s funds management department regarding how and where to raise the money needed? Explain why you make this recommendation
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT