Question

Using the supply and demand for bonds framework, explain the combined effects of the recession and expected deflation caused by the current COVID-19 pandemic and lockdown on the equilibrium nominal interest rate in the absence of any macroeconomic policy interventions. To simplify your analysis, assume that the Government of Canada and the Bank of Canada are not currently implementing any fiscal and monetary policy measures to stimulate the economy. Draw a clearly labeled bond market diagram to support your explanations.

Answer 1

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Question:

Answer:

Bond is a less risky than the equity. During the crisis or recession like COVID-19 pandemic or Corona crisis economy get shrunk rapidly and the increase uncertainity in the economy. Share market or other investment market also get affected during this period. During this period the investors quit from stocks or sell their stocks and buy high rated bond to protect their fund or money. Interest rate negatively affect the bond price. When interest rate increase, bond price decrease and vice-versa. When bond price increase yield decrease and vice-versa. But here, as per the question the Government of Canada and the Bank of Canada are not currently implementing any fiscal and monetary policy measures to stimulate the economy. So, here demand for bond as a safe investment will affect bond market and bond price will increase. During the deflation the borrower do not want to borrow more because due to delation they have to significantly more than what they borrowed.

Graphical representation:

You can see how increasing demand for bond increase price level from P t P1.

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