Sarah Stannard

ECON 3229 H
March 9, 2020
Paper #1

Part 1. Using the loanable funds model of interest rates as outlined in Week 5 slides,
explain in detail the forces that tend to cause short-term and long-term bond yields to move
pro-cyclically-----rising in the latter portion of business cycle expansions, and falling in
periods of recession, as illustrated by the U.S. T bill yield and the 10-year Treasury bond
yield in Figure 3 of Week 5 slides.

On Figure 3 of the Week 5 slides, an interesting trend is shown. The graph clearly shows
that both the 10 year Treasury Bond and the 90-Day Treasury Bill yields share a similar pro-
cyclical pattern. But what exactly causes this trend in both the yields. Ultimately there are three
forces that tie directly to the pro-cyclical trend of short-term and long-term bond yields: business
confidence, consumer confidence, and expected inflation.

Starting at the top, business confidence. A business’s outlook on the economic future of
the country plays an integral role in a country’s GDP. Suppose, the macroeconomic conditions
appear to be rapidly improving. Businesses pay attention and their confidence in the economic
future escalates. So, predicating higher sales in the future, they will decide to borrow more funds
in order to finance additional plants and to buy more equipment. This will shift the demand curve
for loans rightward, boosting interest rates and bond yields. But imagine again, instead of the
economy growing, it enters a recession. All of a sudden, businesses are anticipating less sales.
They no longer have a need to expand their plants or buy new equipment to make inventory they
do not anticipate selling. So instead of seeking more fund to borrow, firms frantically attempt to
pay off their loans and reduce their debt. In addition, with less sales profits start decreasing
which means firms will try to avoid risk. This will shift the demand curve for loans to the left,
causing interest rates and bond yields to fall.
 How does consumer confidence fit into this picture? It actually walks hand in hand with
business confidence. When the economy is booming and expanding, confidence is high. More
people are working and they think the economy will continue to grow. This causes an increased
demand for goods. (Which increases sales for business and cause them to expand as discussed in
the previous paragraph.) In addition, rising consumer confidence will increase demand for loans
to finance large purchases. Think about it, people are more likely to buy a new car, appliances,
and homes if they think the economy will continue to grow. This means that their job is more
secure, there will be potential for them to grow and expand in the future. This also shifts the
demand curve for the loans to the right. Continuing the same scenario from earlier, what happens
to consumer confidence during a recession? Well, now people are losing jobs or worried that
they may lose their job. Money is tighter. Suddenly, having debt is scary and the money they do
have needs to be spent on every day necessities. Instead of buying new things, consumers try to
make do with what they have. This causes the demand for loans to fall shifting the curve to the
left. Just like that, the interest rates and bond yields also fall in the recession.

What about inflation expectations? If inflation is expected to increase, demand for loans
will increase. Borrowing before inflation increases makes the loan cheaper. As inflation
increases, the value of a dollar increases, causing the value of the loan decreases. It becomes
easier to pay the loan off because there is more money. This re-distributes wealth from the
loaners to the borrowers, causing demand for loans to increase which shifts the curve to the right.
In order to make purchasing bonds more appealing, the government must ensure that the interest
rates on the bonds exceed the expected inflation. If the interest rate is lower than the inflation
than the consumer will lose money buying the bond and no one would buy bonds. Since inflation
has a pro-cyclical nature, it directly encourages the pro-cyclical nature of the interest rates of
short-term and long-term bonds.

Ergo, there are many factors that encourage both short-term and long-term bond interest
rates to move procyclical. However, three factors outlined today are consumer confidence,
business confidence, and expected inflation.
2. Using the loanable funds model of interest rates, explain the forces contributing to the
tendency for U.S. bond yields to be highly correlated over time with bond yields in other
major industrial nations, as illustrated in Figure 6 of Week 5 slides.

In the twenty-first century, it is nearly impossible for a country’s GDP to remain

independent from economic factors in another country. Today, countries heavily trade with one
another and invest in other countries. Because of this, the U.S bond yields have a tendency to
correlate with bond yield in other nations. This is exhibited in Figure 6 of the week 5 slides.
Here, the yields of 10-year government bonds in both the U.S. and Germany are plotted over
time. The graph shows a clear tendency of bond yields in one country to correlate with yields in
another. Behind the graph, there are several factors that influence this correlation, the Safe
Haven effect, the interconnectivity of business cycles and the interconnectivity of the world in
general.
One of the major forces on the U.S. bond yields over time is the Safe Heaven effect. This
happens in sever economic or political instability. This instability causes capital flight to take
place. If there is increased instability in Europe the direct effect on the U.S. is a decrease in bond
yields. For example, the Germany starts to experience a recession, but the U.S. starts enters into
an expansionary phase. Agents will start selling their Germany securities and start buying
securities from the U.S. This will decrease the supply of loanable funds in the U.S., causing the
interest rates to fall. A decline in interest rates will also decrease the bond yields. Ergo, the
economic stability of Germany will directly correlate to bond yields in the U.S. However, it is
important to note that this effect is normally only seen in times of sever economic or political
instability. Ergo, it is normally seen in non-industrialized countries like Venezuela, not Germany.

Similar to the Safe Haven effect, the pool of financial capital plays a large role in the
correlation between bond yields in countries. This is a large pool of loanable funds. However,
this pool readily flows from unstable countries to more stable countries or countries that have
relatively more attractive yields. Unlike the Safe Haven effect, this force is not dependent on
extreme economic or political instability. Whenever the interest rates fall in Germany, large
financial capital investors realize that German securities are not as profitable as a U.S. bond. Due
to this, loanable funds flow out of Germany and into the U.S. This will cause the U.S supply
curve for loanable funds to shift to the right, pulling down bond yields.

Another major force is how business cycles tend to be transmitted from one country to
another. If a country is experiencing an economic boom, they will increase their demand for
imports and foreign products. This demand will decrease supply of imports. To compensate for
their decreased supply, foreign companies will start to increase their production and production
investments. This will increase job opportunities and wealth in industrial countries. If a country
were to experience a recession, the opposite would happen. How does this look practically?
From 2008-2009 the US entered a recession due to the financial crisis. Since the U.S. was in a
recession, their interest rates were naturally following as explained in the previous paper. During
this time, the U.S. decreased their demand for German goods. This decrease in demand caused
the German interest rates to also fall. Figure 6 clearly illustrates this. This U.S bond yields fell by
about 1% during 2008-2009, but the German bond yields also fell by roughly 1% during the
same time frame. This also relates to the inter-connectivity of our business worlds. For example,
the most recent developments with the COVID-19 virus in China has caused entire cities in
China to shut down. This means that businesses and factories are not operating. It also means
that consumers are not shopping. Undoubtedly China is in an economic slow down and could
potentially fall into a recession depending on how long they remain in lock down. However, this
has major implications for other industrial countries around the world. Many major U.S.
companies have active factories in China. Factories that produced needed inventory or parts for
these companies. This is creating a major supply chain crisis for many major companies. Which
has the potential to spread the economic downturn from China around the world.

Finally, many fundamental forces that impact interest rates in the U.S. tend to occur not
just in the U.S. but in numerous nations across the globe. Continuing the with COVID-19
example, the supply chain crisis is not just impacting U.S based companies. It is also impacting
companies like Toyota (a Japanese company) and any other company with factories in China. If
this crisis leads to a worldwide recession, the bond yield will decrease around the globe as
interest rates fall decreasing demand. Another example of this, can be seen during the collapse of
oil prices n 2014-2016. This pushed inflation down which caused bond yields to fall. Because oil
is so widely used around the country, it impacted both Europe and the U.S..

Ultimately, there are many forces and factories that cause the correlation between bond
yields in industrial nations. Most of these forces are interwoven themselves. As nations continue
to invest in each other through factories and the pool of loanable funds, they will increase the
correlation of bond yields between nations. At the end of the day, some of the major forces as
discussed are the Safe Haven Effect, the tendency of business cycles to be transmitted, the pool
of financial capital, and the fact that fundamental forces influencing interest rates in once country
tend to occur in numerous nations at the same time.