The Liquidity Preference Framework

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(8 points) Data observation shows that the yield curve is likely to be upward sloping at the start of expansion. Explain these observations using both the bond supply and demand analysis and expectation hypothesis theory.

(4 points) First the bond supply and demand analysis and data observations imply that the interest rate is procyclical. When the economy is heading for expansion, the bond supply increases due to more profitable investment opportunities. The bond demand increases as well, but the increase is typically dominated by the increase in the bond supply. As a result, bond prices decreases, and the interest rate is expected to increase at the start of expansion.

(4 points) According to the expectation hypothesis, the interest rate on long term bonds are averages of expected short term rates. Since the market expects short term rates to increase at the start of expansion, long term rates will be higher than the short term rates, leading to an upward sloping yield curve.

2. 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).

The liquidity preference framework.

When the economy booms, the demand for money increases: people need more money to carry out an increased amount of transactions and also because their wealth has risen. The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. The opposite is true at the time of recession.

The bond supply and demand framework.

When the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises....
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