Question

How the shape of yield curve might change when:

• Central bank adopts an explanatory monetary policy
• Market participants expect an increase in inflation in the future

Answer 1

When central bank adopts expansionary monetary policy it uses the tools to stimulate the economy in a way that increases the money supply in the market, lowers the interest rate and increases the aggregate demand in the economy. And at the same time when the market participants expect an increase in the inflation in the future i.e they expect the economy to expand and the interest rate that they are going to get must be higher as it eats away thaur returns. As the yield curve expands when inflation rate is higher and also the interest rate to set off the inflation is also higher. If the inflation rate is higher and the yield that they are offering is relatively lower then the yield curve will be contracts as the same will be applicable as they are having the inverse relationship. The expansionary monetary policy will be aiming the reduced interest rates and the optimal rise in the inflation whereas to the contra if the inflation is rising and the interest rates are decreasing due to the adoption of the policy then the yield curve will be move in invertive direction i.e inverted yield curve if all the other things being normal.