Question

1. What does the slope of the yield curve tell us? Suppose that economy is in recession and monetary authority decreases policy rate (interest rate) to return output to its potential level. Illustrate using relevant graphs when the yield curve is i) approximately horizontal ii) downward sloping (Hint: Use expectations augmented IS-LM model.)

Answer 1

As we know, yield curve gives us useful information about yield rates of similar securities at different maturities, the slope of the curve gives us a rough idea about the interest rate changes in the future and the trends in economic activity in the respective region.

In this analysis, I would not use the augmented expectations model of IS-LM. Rather I have provided a straightforward explanation to understand the logic behind the nature of these types of yield curves.

i)

Let us take a look at an approximately horizontal yield curve, also known as flat yield curve given below.

As you can see the curve is almost horizontal, the practical implication of this trend is pretty easy to understand. In this case, the economy is recovering from recession and is in a transition for a potential expansion as well. Therefore, yields on longer-maturity securities are set to rise due to this anticipated expansion which is triggered by the lowering of interest rates by monetary authorities. And on the other hand, yields on shorter-maturity securities will fall due to the recession, thereby tilting the inverted yield curve (downward sloping) into an almost flat (horizontal) curve as shown in the image above.

ii)

Downward sloping also known as the inverted yield curve, suggests us that yield on longer duration securities ought to fall during a recession. The image below shows us the inverted yield curve.

In simple, securities with shorter maturity result in higher yields than those securities with higher maturity. This critical situation is often used as an indicator to predict recession, and in most of the cases this trend is followed by a recession. In a normal yield cuve the scenario is just the opposite. The same reason cited in flat yield curve applies here too. Due to the recession, the investors become pessimistic and therefore expect low returns in long maturity bonds and in turn expect higher returns in the shorter maturity bonds as the interest rates is bound to fall in the long run anyways.

Hope this helps you understand the concept. Cheers!