Question

a) The following graph depicts the slope of the yield curve for the US (the difference in yields of 10 years and 2 years bonds). Explain what market expectations regarding future short term nominal interest rates as revealed by this curve (especially when compared against the last 3-4 years). Provide a discussion of relevant theories in support of your explanations. [5096] The Mysteriously Flattening Yield Curve Spread of 10-year over 2-year Treasury yields 300 250 200 150 100 50 2007 09 13 15 17 Source: Bloomberg O FT b) Given that the graph above shows an almost flat yield curve (slope close to zero), what lessons can we draw for future expected inflation and economic growth in the US? [2096] Explain your answers. c) Assume a central bank sells a part of its foreign reserves. What impact on domestic interest rates would this measure have? Describe what the bank could do to neutralise the impact of this transaction on interest rates.

Answer 1

Solution A

The yield curve and interest rate have aleays seen inverse relationship and historically the Yield curve inverts which indicates coming recession as seen from graph by 2020 second half in USA. This suggest that as yields go down the interest rates climb further which is case of Contractionary monetary policy and hence leads to shrinkage of real GDP and prices which eventually can lead to potential recession.

Solution B

The future economic growth looks fairly slumped with decreased or flattened yield which is strong indicator of gradual rise in interest rates. Hence inflation shall remain subdued in future. This is strong indicator of robust economy in near terms however can also lead to recession if an expansionary fiscal policy is not adopted effectively .

Solution C

If central bank sells part of the foreign reserves it will increase money supply in market which means the demand for domestic currency decrease and hence interest rates fall in convergence. To neutralise the impact of transactions the central bank can adopt contractionary monetary policy by increasing cash reserve ratio such that interest rates increase in short term.