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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.

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Expert Solution

The business cycle is the fluctuation of the economic variables around their trend. There are two phases of business cycle: recession and inflation. The recession occurs when growth rate of economic indicators such as GDP, investment, unemployment, profits falls for two consecutive quarters.

The interest rate in recession falls. The figure below describes the bond and the money market of an economy.

The demand for money is an inverse function of rate of interest. The supply for money is constant and determined by the Fed. The money market is in equilibrium where the demand for money is equal to supply of money. The interest rate at which the money market is in equilibrium is called equilibrium rate of interest.

The nominal interest rate or market interest rate is the price of a lone and it is determined by the interaction between demand for and supply of loanable funds in the market. Anything that either affects demand for or supply of the loanable funds will affects the interest rate. There are four factors that affect the supply and demand for loanable funds are:

  • Supply of loan.
  • Real GDP.
  • The price level.
  • The expected inflation rate

In recession the demand for money falls because the aggregate demand in the market falls and people makes less transaction due to fall in income. The fall in demand for money gives supply decreases interest rate in the market. At the same time the fall in real GDP decreases the demand for loanable funds in the market and demand for investment shifts down (from I to I'). At the equilibrium both amount of loan and interest rate falls in the economy.

Rahul Sunny answered 2 years ago
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