Question

Assume that inflation is expected to decline steadily in the future, but that the real risk rate will remain constant. which of the following statements is correct.

1. if inflation is expected to decline, there can be no maturity risk premium

2. the expectations theory cannot hold if inflation is decreasing

3. if the pure expectations theory holds, the corporate yield curve must be downward sloping

4. if the pure expectations theory holds, the treasury yield curve must be downward sloping

5. if there is a positive maturity risk premium, the treasury yield curve must be upward sloping

Answer 1

When the inflation is expected to decline in future and the real risk free rate will be remaining constant, then it will mean that there is lack of demand into the economy and it would be expected that there would be an inverted yield curve and downward sloping yield curve due to lack of demand.

So if the pure expectation theory will be holding, it will mean that the treasury yield curve will be downward sloping because there would be an expectation of impending recession due to declining of inflation and constant risk free return.

Otherr statements are not true because they are not representing the true scenarios.

Correct answer is option (4) if the pure expectation theory holds, the treasury yield curve must be downward sloping.