Question

You are currently working as an economic adviser to the Central Bank of Morrisland. While going through a report that examines the current economic conditions, you find that all leading indicators point towards a recession in the economy. Using the bond market diagrams, show the effect of this unfolding event on the interest rate.

Answer 1

As economy is heading towards recession, Central Bank should buy bonds from the market such that they reduce the supply of bonds in the market and give money in exchange of bonds to public. As they give money in exchange of bonds which inject the money in the economy and give more money in the hands of public to spend on goods and services which raises their willingness to pay for goods and services. Rise in willingness to pay for goods and services raises the aggregate demand in the economy and prevent economy from going into recession. Reduction in supply of bonds will raise the rate of interest from "i" to "i1" and reduce bonds traded from "Y" to "Y1" and shift the bond market equilibrium from point A to B .