Question

Discuss the various theories related to the term structure of interest rates. What are the strengths and weaknesses of each of these approaches. What are the implications of the empirical results related to the term structure? What are some of the reasons that we could have a downwardly sloped yield curve? What are the implications of a downwardly sloped yield curve?

Answer 1

The different theories of term structure are:

1. Expectation Theory - When the expectation are that the short term interest rates will be higher leads to s positive yield curve and when the expectations are that the short term interest rates will be lower will lead to a negative yield curve

2. Liquidity preference theory - This states that investors prefers liquidity than anything else. Hence they prefer short term debt than long term debt as these are more liquid.

3.Segmented Market theory - This states that different investors in the market confine themselves to different maturities. Hence the prevailing investment policies define the yield curve.

When the inflation rates fall, the growth rate of the economy slows, the unemployment rises will lead to a downward sloping yield curve.

The implications of a downward sloping yield curve is the the central bank will lower the interest rates and hence there will be more liquidity. When the interest rates are lowered there will be a spur of investment and that will lead to higher growth and stabilize  the economy.