Question

Discussion Topic #5 (Chapter 6) Suppose the Federal Reserve System has just announced that it will greatly expand the money supply to boost the economy. Discuss what effect this will have: (a) On the level and slope of the yield curve immediately after the announcement (b) On the level and slope of the yield curve that would exist two or three years in the future?

Answer 1

Sol :

(a) We know that in general Federal Reserve System adopts expansionary policy to expand the money supply to boost the economy and this policy has major immediate effect on the level and slope of the yield curve and this will decrease the  short-term interest rates, generally intended to lead to a reduction in deflationary pressures. This increase in money supply accelerates the economy and it makes the yield curve steep. A steep yield curve is commonly a positive sign for the economy. It demonstrates speculators or investors are certain about putting money into stocks and private securities, therefore long term government securities have to offer higher yields to pull in buyers.

(b)The effect of Federal Reserve System's expansionary policy to expand the money supply on the level and slope of the yield curve that would exist two or three years will not be same as it was in the previous case. Here the curve will be flat and it would imply that economy is slowing down and investors are unsure about the future way of the economy.