Why Nominal Interest Rate Is Pro-cyclical?


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In expansionary economy, real GDP increases and wealth also increases. As we all know, increase in wealth would make the demand for bond higher as people have more purchasing power. Quantity demand of bond shifts to the right. What happen to supply of bond? Business are booming and have higher incentives to invest and need more fund for that. Supply of bond increase and quantity supply of bond shifts to the right as well. Now what happen to interest rate? It depends on the magnitude change of supply and demand. However, empirically studies shown than supply would increase further than demand pushing the interest rate to increase and price of bond decrease. So, when there is expansion, interest rate would increase and during recession interest rate would decrease( this is called pro-cyclical).
For more understanding use the loanable funds framework.

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