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Do you agree or disagree with the following statement? Explain your answer. "Assume there is no...


Do you agree or disagree with the following statement? Explain your answer. "Assume there is no liquidity premium and investors have no maturity preferences. If inflation is expected to steadily increase over the next few years and the real rate of return is expected to remain the same, the yield curve should be downward sloping."

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Answer #1

The statement is false.

Yield curve shows a relationship between interest rate and years to maturity.

Although there is no liquidity premium or maturity preferences, the inflation rate is expected to steadily increase and that will increase the inflation premium. Inflation premium is one of the component of interest rate.

Interest rate = Real risk-free rate + inflation premium + liquidity premium + maturity premium

From the above equation, it can be concluded that interest rate will increase as a result of increase in inflation premium. Clearly, the yield curve would be upward sloping as interest rate is increasing with time.

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