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For this question, suppose the economy is entering a recession. (a) Use the Liquidity Preference (Money...

For this question, suppose the economy is entering a recession.

(a) Use the Liquidity Preference (Money Market) Framework to illustrate what would happen to interest rates. Be clear about what channel(s) are affected.

(b) Use the market for government bonds to illustrate what would happen to interest rates. Be clear about what channel(s) are affected.

(c) What must be true for the predicted impact on interest rates to be consistent between the Liquidity Preference Framework and the Market for Bonds Framework

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Answer #1

a) The liquidity preference framework: When the economy is in recession, the demand for money decreases, people need lesser money to carry out the decreased amount of transactions and also because their wealth has fallen. The demand curve, Md, thus shifts to the left, lowering the equilibrium interest rate.

b) When the economy is in recession, the demand for bonds decreases: the public’s income and wealth falls while the supply of bonds also decreases, because firms have lesser attractive investment opportunities. Both the supply and demand curves shift to the left, but the demand curve probably shifts less than the supply curve so the equilibrium interest rate falls.

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