Question

6. Suppose the economy has an inverted yield curve. Using the liquidity premium theory explain what this means for future short term interest rates. What does this imply about the business cycle? (5 pts)

Answer 1

When economy has an inverted yield curve, the liquidity premium theory suggests that the investors expect an economic slowdown. The inverted yield curve arises when the short-term interest rates exceeds the historical averages because the investors have a greater expectation that rates will falls, and consequently the long term bond issuers would be reluctant for the bonds issuance with higher rates when investor expectation is that lower rates will prevail in the near future. This is an indicator of economic recession i.e. economic downturn