Question

1.How does the liquidity premium theory explain an upward sloping yield curve during normal economic times?

Answer 1

According to the liquidity premium theory, the interest rates of unlike maturities will move alongside for the reason that the long-term rates are for all intents and purposes tied to the short-term rates. Also, there will be less volatility of long rates, as part of the long rate (which is actually an average of the short rates), will eventually deal with or remove the volatility in the short rates. And in conclusion, the yield curve will normally slope upwards as the risk premium increases with time to maturity.