According to empirical evidence, nominal interest rates are procyclical. They rise when the economy booms and...

According to empirical evidence, nominal interest rates are procyclical. They rise when the economy booms and they fall during recessions. Is this empirical evidence consistent with DAD-DAS models? Explain and use graphs to illustrate your answer.

Expert Solution

Economy booms: People have more cash in their hands which raise their willingness to pay for all the goods and services which will raise the aggregate demand and shift aggregate demand to its right from AD to AD1 while aggregate supply remains the same. It will raise the price level as well as output level.

When consumption shifts right, aggregate demand rises which shifts the IS curve to its right. It raise interest rate from i to i1.

Economic recession: People have less cash in their hands which reduce their willingness to pay for all the goods and services which will reduce the aggregate demand and shift aggregate demand to its left from AD to AD1 while aggregate supply remains the same. It will reduce the price level as well as output level.

As consumption level falls, aggregate demand would fall which will shift the IS curve to its left reducing rate of interest from i to i1.

Thus we can say that interest rate changes as economic conditions changes.

Rahul Sunny answered 2 years ago

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