Why Interest Rates Are Procyclical.

Question:
Using the supply and demand for bonds framework, show why interest rates are procyclical (rising when the company is expanding and falling during recessions).

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Answer:

In a business cycle expansion, the amounts of goods and services being produced in the economy increases, so national income increases. When this occurs, business will be more willing to borrow, because they are likely to have many profitable investment opportunities for which they need financing. Hence, at a given bond price, the quantity of bonds that firms want to sell (that is, the supply of bonds) will increase. This means that in a business cycle expansion, the supply curve for bonds will shift to the right.

Expansion in the economy will also affect the demand for bonds. As the business cycle expands, wealth is likely to increase, and then the theory of asset demand tells us that the demand for bonds will rise as well. This means that in a business cycle expansion, the demand curve for bonds will shift to the right.

Given that both the supply and demand curves have shifted to the right, we know that the new equilibrium reached at the intersection must also move to the right. However, depending on whether the supply curve shifts more than the demand curve, or vice versa, the new equilibrium interest rate can either rise or fall.

Impact of Increased Expansion

On the contrary, in a business cycle recession, the amounts of goods and services being produced in the economy decreases, as a result, national income decreases. When this occurs, the supply and demand curve for bonds will shift to the left. The new equilibrium reached at the intersection must also move to the left. However, depending on whether the supply curve shifts more than the demand curve, or vice versa, the new equilibrium interest rate can either rise or fall.

Impact of an Economic Slowdown

In a nutshell, depending on whether the supply or demand curves shifts more to the right (or left), the equilibrium rate can rise or fall. However, historical data indicates that the interest rate is procyclical; rising when the company is expanding and falling during recessions. Just as economic growth puts upward pressure on interest rates, an economic slowdown puts downward pressure on the equilibrium interest rate.

Reference:

1. Mishkin, F. S., & Eakins S. G. (2011) Financial Markets and Institutions (7th ed.) Pearson.
2. Madura, J. (2010) Financial Institutions and Markets (9th ed.) South-Western Cengage Learning.

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