CHAPTER 4 Why Do Interest Rates Change? 123 l, Reto 18 16 14 12 10 8 6 4 Interes
ID: 1153579 • Letter: C
Question
CHAPTER 4 Why Do Interest Rates Change? 123 l, Reto 18 16 14 12 10 8 6 4 Interest Rate 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 FIGURE 4.7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951-2013 Shaded areas indicate periods of recession. The interest rate tends to rise during business cycle expansions and to fall during recessions Source: Federal Reserve Bank of St. Louis FRED database: http:fresearch.stlouisfec.orgtred2. CASE Explaining Low Japanese Interest Rates In the 1990s and early 2000s, Japanese interest rates became the lowest in the world. Indeed, in November 1998 an extraordinary event occurred: Interest rates on Japanese six-month Treasury bills turned slightly negative (see Chapter 3). Why did Japanese rates drop to such low levels? In the late 1990s and early 2000s, Japan experienced a prolonged recession, which was accompanied by deflation, a negative inflation rate. Using these facts, analysis sim- ilar to that used in the preceding application explains the low Japanese interest rates. Negative inflation caused the demand for bonds to rise because the expected return on real assets fell, thereby raising the relative expected return on bonds and in turn causing the demand curve to shift to the right. The negative inflation also raised the real interest rate and therefore the real cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift to the left. The outcome was then exactly the opposite of that graphed in Figure 4.4: The rightward shift of the demand curve and leftward shift of the supply curve led to a rise in the bond price and a fall in interest rates. The business cycle contraction and the resulting lack of profitable investment opportunities in Japan also led to lower interest rates, by decreasing the supply of bonds and shifting the supply curve to the left. Although the demand curve alsoExplanation / Answer
This observation makes perfect economic sense.
During economic expansion, economic activity rises. Firms increase production and output, and invest more into their business. This increase in investment is most commonly borrowed from funds market where, an increase in demand for investment shifts the investment demand curve rightward, increasing interest rate.