Question

Using both the liquidity preference framework and the supply and demand for bonds framework, show:

A. Why interest rates are procyclical (rising when the economy is expanding and falling during recessions.)

B. How interest rates are affected when the liquidity of bonds falls? Are the results the same in the two frameworks?

Answer 1

Part 1) The reason why interest rates are pro-cyclical is that as the economy expands the income of people increases. For a given level of money supply people start to withdraw money from their speculative balances to finance their increased transaction needs. This puts pressure on the interest rate. To keep the financial markets in equilibrium the interest rate need to rise to create incentive for the people to invest. The opposite is true during recession.

Part 2) When the liquidity of bonds fall the interest rate rises. This is because the main function of money is to smoothen the transactions, and if bonds cannot be easily converted into money then people will need incentive to block their money in such financial instruments. The result is same in both the liquidity preference framework and the supply and demand for bonds framework.