Question

1. How does expected inflation rate affects interest rate? Use the demand and supply in the bond market to explain your answer.

2. Differentiate the Expectation theory and Market Segmentation theory in explaining the yield curve?

Answer 1

1)

When inflation expectations rise, therefore, investors demand a higher interest ratefor their investment as compensation for that lost value, other things being equal.Demand for bonds falls, bond prices fall, and interest rates rise. When inflationexpectations decline, investors will be more willing to lend money

The Effect of Rising Inflation Expectations on Demand for Bonds Demnand 2 Demand 1 Price of Bonds Quantity of Bonds

HIGHER INFLATION EXPECTATION: Willing to borrow money- supply increases -Bond price fall -Interest rate Decreases

LOWER INFLATION EXPECTATION :   borrower less interest to issue bond -supply Decreases -bond price Rise-interest rate increases

The Effect of Rising Inflation Expectations on the supply of Bonds Supply 1 Supply 2 Price of Bonds Quantity of Bonds

The Effect of Rising Inflation Expectations on the supply of Bonds Supply 1 Supply 2 Price of Bonds Quantity of Bonds

Higher inflation expectations decrease demand for bonds and increase their supply. Both factors result in lower bond prices and higher interest rates.

Lower inflation expectations increase demand for bonds and decrease their supply. Both factors result in higher bond prices and lower interest rates.

2)

Market segmentation

Market segmentation theory is a theory that long and short-term interest rates are not related to each other. It also states that the prevailing interest rates for short, intermediate, and long-term bonds should be viewed separately like items in different markets for debt securities.

Market Segmentation Theory ( MST ) posits that the yield curve is determined by supply and demand for debt instruments of different maturities. Generally, the debt market is divided into 3 major categories in regard to maturities: short-term, intermediate-term, and long-term.

Expectations theory

Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today. The theory is also known as the "unbiased expectations theory.

Yield curve:

A flat curve generally indicates that investors are unsure about future economic growth and inflation.The expectations theory states that expectations of rising short-term interest rates are what create a positive yield curve.

Term Structure Normal Humped Steep Maturity Maturity Yield Inverted Maturity Flat Maturity Maturity WallStreetMojo