Question

Using either the liquidity preference framework or the classic framework (supply and demand of bonds) to predict how interest rate change and give brief explanation of your prediction.

1. Economy is expanding;
2. Expected inflation rate increases;

Answer 1

The liquidity preference framework. When the economy booms, the demand for money increases: people need more money to carry out an increased amount of transactions and also because their wealth has risen. The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. The opposite is true at the time of recession.

The bond supply and demand framework. When the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. The opposite is true when recession happens. Thus interest rates are seen to be procyclical.