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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

01

To determine

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

02

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.

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Most popular questions from this chapter

Increasing prices erode the purchasing power of the dollar. It is interesting to compute what goods would have cost at some point in the past after adjusting for inflation. Go to http://minneapolisfed.org/index.cfm. What would a car that costs $22,000today have cost the year you were born?

Go to the St. Louis Federal Reserve FRED database, and find data on net worth of households and nonprofits (HNONWRQ027S) and the 10-year U.S. Treasury bond (GS10). For the net worth indicator, adjust the units setting to “Percent Change from Year Ago,” and for the 10-year bond, adjust the frequency setting to “Quarterly.”

a. What is the percent change in net worth over the most recent year of data available? All else being equal, what do you expect should happen to the price and yield on the 10-year Treasury bond? Why?

b. What is the change in yield on the 10-year Treasury bond over the last year of data available? Is this result consistent with your answer to part (a)? Briefly explain.

Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?

Go to the St. Louis Federal Reserve FRED database, and find data on the M1money supply (M1SL) and the 10-year U.S. Treasury bond rate (GS10). For the M1money supply indicator, adjust the units setting to “Percent Change from Year Ago,” and for both variables, adjust the frequency setting to “Quarterly.” Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year Treasury rate on the vertical axis, from 2000:Q1to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are several ways to do this; however, one particular chart layout has this option built in). Based on the fitted line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the interest rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2000:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected-inflation effects.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11of this chapter?

Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?
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