In January 2005, the interest rate on bonds was 4% a year and it was expected it to rise to 5% a year by the end of 2005. As the rate rose to 4.3% during February, most commentators focused, not on why the interest rate rose, but on why it was so low before. Explanations of this ‘conundrum’ included that unusual buying and expectations for an economic slowdown were keeping the interest rate low.
a. Explain how “unusual buying” might lead to a low real interest rate.
b. Explain how investors’ “expectations for an economic slowdown” might lead to a lower real interest rate.