Q.22 聽Using both the liquidity prefe... [FREE SOLUTION]

Chapter 5: Q.22 (page 165)

Using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions)

Short Answer

Expert verified

The amount demanded of an asset is directly related to wealth, expected return on asset, and liquidity of the asset, and negatively proportional to expected return on alternative asset, liquidity of the alternative asset, according to the theory of portfolio choice.

Step by step solution

To determine

The supply and demand of bonds framework, as well as the liquidity framework, are used to explain why interest rates are cyclical.

Explanation

When the economy is booming, people's wealth rises along with investment opportunities. The bond's demand and supply curves both shift rightward as a result of this, but the demand curve's movement is less than the supply curve's. It results in a drop in pricing and an increase in interest rates. In the liquidity framework, during a boom era, both demand and supply of money increase, but demand exceeds supply, causing the interest rate to rise.

During a recession, people's wealth levels are reduced, and company investment opportunities drop as well. Bond demand and supply both fall as a result of this, but supply falls faster than demand, resulting in an increase in prices and a decrease in the interest rate. In the liquidity framework, in a recessionary time, both demand and supply of money decline, but demand decreases more than supply, lowering the interest rate.

Interest rates are thus pro-cyclical.