Question

By using the supply and demand for bonds framework , show why interest rates decline during the economic recession?

Answer 1

A bond is a type of loan. When one buy a bond, he is lending money to the article that issued the bond. In exchange, the issuer is obliged to repay the original loan amount plus interest over the life of the bond. The bonds are issued by federal and local governments, businesses, and other government agencies. Bonds and interest rates have a negative relationship, so if the prices of bonds rise, interest rates decrease. When interest rates are low, bond prices are high. When interest rates are low, bond prices are high. When the low interest rates cause higher bond prices and produce lower return on investment, the demand for bonds is low. However, as price of bonds that offer bonus increases, the interest rates tends to decrease. Although several factors influence the supply and demand for bonds, which in turn influences interest rates.

Interest rates play a key role in the economy and in the process of the economic cycle of expansion and recession. What happens to interest rates during recessions is thus a product of the interplay between all these forces, groups, and institutions. Interest rates typically fall during recessions due to massive expansionary monetary policy. When an economy enters recession, demand for liquidity increases but the supply of credit decreases, which would normally be expected to result in an increase in interest rates.

However, a central bank, such as the Federal Reserve, can use monetary policy to counteract the normal forces of supply and demand to reduce interest rates, and therefore we see falling interest rates during recessions.