Question

If a higher inflation is expected, what would you expect to happen to the shape of the yield curve as per the pure expectation theory? Why? Draw the diagram and explain.

Answer 1

Pure expectation theory

It is also known as Market expectation theory. According to this theory, different maturities are the substitutes and the expecting rate of interest in the market decides the shape of the yield curve.

Yield Curve

Yield curve is a single line which depicts the rate of interest at different maturities. Maturity period may be months to years. Debts in the market depends on yield curve. It serves as a predictor of the economic changes and development. Shape of the yield curve depends on several factors. They are:-

• Interest rates of subsequent years (Key factor)
• Preference of investors
• Liquidity premium for long-term investments
• Demand
• Fund supply
• Overall condition of economy

Conclusion

If inflation will occur in the economy in the coming years, it can be analyzed by the rise in the rate of interest in the subsequent years. Because rate of interest and inflation will move together in the parallel direction. Hence, we can know whether a higher inflation is going to happen in the coming future or not, by analyzing the movement of rate of interest. When the rate of interest increases, the rate of inflation in the market will increase suddenly. Hence, we can said that a higher inflation can be expected whenever there is a high rate of interest occur in the economy. Also, inflation will occur as a result of economic expansion. Economic expansion can be said as a period of development of the economy. GDP rate will also increase by that time.

Thus, when such a higher inflation is expected in the future, shape of the yield curve will be a steep upward slope at longer maturities.

Shape of the yield curve can be depicted with the help of a diagram.