Question

a. State the Pure (Unbiased) Expectations Theory.

b. How is the liquidity preference theory supposed to address the shortcomings of the pure expectations theory? (Hint: Time to maturity and liquidity premium)

c. Briefly discuss how the liquidity preference theory explains the shape of the yield curve. (HInt: Time to maturity and liquidity premium)

Answer 1

Pure (Unbiased) Expectations Theory, also known as Expectations Theory, predicts future interest rates in the short-term based on the assumption that long-term interest rates are indicators for the future, thus indicating that the long term interest rate hold a forecast for short-term interest rates in the future. The theory is used as an explanation for yield curve. But theory has been considered to be inaccurate in execution as interest rates typically stay flat when yield curve is normal. The expectations theory essentially is known to over-estimate short-term interest rates in the future.