Question

It is widely assumed that an economic recession, combined with an expectation of declining inflation (maybe even a deflation), will generate very low (maybe even negative real) interest rates. Using the bond market, discuss the impact on interest rates of i. a recession, ii. an expected decline in future inflation rates. Does your analysis support the notion that deflationary recessions can generate very low interest rates?

Answer 1

i) Interest rate rarely tend to increase during recession . In fact it falls during recession.During recession the Fed tries to keep interest down to stimulate the economy.During recession people do not want to spend and borrow money but want to save. The demand for money falls and pushes interest rate downward.The Fed exerts influence on interest rate. It can push the rate up or down by federal funds rate and by buying or selling bonds. It tries to keep interest rate low to stimulate the economy.When interest rate begin to drop during recession bond prices may go up.

ii) When inflation expectations decline,investors will be more willing to lend money. Demand will rise, bond prices will rise and interest rate will fall.

To encourage spending during deflation the government cannot reduce interest rate to negative level or zero.Central banks can only reduce the rate by certain amount.So interest rate cannot be very low.