Question

Considering the expectation theory and the term structure of interest rate, why is it that, in general, the cost of borrowing/interest rates for businesses tend to be low when the economy is doing very well.

Answer 1

Answer:

Expectation theory- This theory uses long term bond rates to predict the short term bond rates.

Term structure of interest rate- It tells the relationship between yield of bonds and maturity of bonds. It says, bonds with longer maturity have higher yields. The yields of short term bonds are more volatile than yields of long term bonds. When interest rates rise, demand for short term bonds increase faster than demand for longer term bonds.

When economy is growing and doing well, it has enough liquidity all over it, Federal reserve has enough funds and it lowers the reserve ratio and federal fund rates so banks can borrow at lower interest rate from Fed, they can lend funds to people at low interest rate so as to create demand for loan, they decrease the rate of interest.