Question

Briefly explain what typically happens to interest rates during a recession. Use a demand and supply graph for bonds to illustrate your answer.

A. The demand for bonds increases, while the supply of bonds decreases, resulting in a lower equilibrium interest rate.
B. The demand for bonds increases, while the supply of bonds increases by a greater magnitude than demand, resulting in a higher equilibrium interest rate:
C. The demand for bonds decreases, while the supply of bonds increases, resulting in a higher equilibrium interest rate
D. The demand for bonds decreases, while the supply of bonds decreases by a greater magnitude than demand, resulting in a lower equilibrium interest rate.

Answer 1

During a recession, interest rates typically decrease. The correct scenario for what happens in the bond market during a recession is that the demand for bonds decreases, while the supply of bonds increases, resulting in a higher equilibrium interest rate.

Step-by-step explanation:

During a recession, typically the interest rates tend to decrease. This is due to a decline in borrowing and spending, as businesses and consumers cut back on investment and expenditure. The laws of demand and supply explain this relationship; as the interest rate falls, the quantity of financial capital demanded increases, while the quantity supplied decreases. This is reflected in the bond market where the demand for bonds may increase due to their safer nature as an investment, and the supply may also reduce as there is less borrowing demand.

When we consider the options provided:

• A. Incorrect because during a recession the supply of bonds typically increases as governments issue more debt to stimulate the economy.
• B. Incorrect because although the supply of bonds might increase, the demand does not necessarily increase by a lower magnitude.
• C. Correct because the demand for bonds typically decreases as investors move to safer assets and the supply of bonds increases as governments issue more debt to finance stimulus measures, resulting in a higher equilibrium interest rate.
• D. Incorrect because the supply of bonds is unlikely to decrease during a recession. Therefore, the correct scenario during a recession is mostly represented by option C: The demand for bonds decreases, while the supply of bonds increases, resulting in a higher equilibrium interest rate.