Question

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

I

S

-

LM

model)

Answer 1

In the is-lm model IS curve shows the equilibrium of the commodity market and LM curve shows the equilibrium of the money market.now we can also call the yield curve and it is downward sloping.the IS curve shows us different combinations of rate of interest and national output or yield.from the downward sloping we can say there is a negative relation between rate of interest and yield.if rate of interest is high then national output is low and when rate of interest is low national output is bigger.

Now we assume that the economy is in recession.to overcome from.this situation central bank decreases interest rate.now we can see the effect of the decrease in the economy asin the initial diagram we measure rate of interest on vertical axis and output level on horizontal axis.now the initial rate of interest is r1 and output is Y1.and it is determined by the intersection of is-lm curve.now at that point the country face recession.so to overcome central bank decrease interest rate.as interest rate decreases then the profiability of money or capital increases.so businessmen and investors are want to take more loans and investing in productive sectors.now if bank gives more loans then the money supply in the economy increases and as money supply increases the lm curve shifts from LM1 to LM2.and when the money supply increases individuals holds more money than before.so individual increases demand for products and wants to pay higher than before as they holds more money.so there is excess supply in the commodity market and producing more goods is profitable now and also rate of interest decreases.so to produce more goods producer needs more capital and also labour.so the demand for labour increases.and more and more labour will get work so the employment level will rise.and the unemployment rate in the country decreases.and as more workers getting work they also get wage rate for participating in the production process.now those workers also go to the market and increase the market demand.and this process continues overtime so the total output of the country increases and the country will overcame the situation of recession.this is shown in the above diagram where the output level increaees fromY1 to Y2.