Question

Suppose a new, highly liberal Congress and presidential administration were elected. The first order of business for these bodies was to take away the inde- pendence of the Federal Reserve System and force the Fed to greatly expand the money supply. What effect would this change have on the level and slope of the yield curve in the following circumstances? a. Immediately after the announcement

b. Two or three years in the future

Answer 1

(a): All else being equal a larger money supply lowers the market interest rates. Thus initially the interest rates will decline and short term rates will be temporarily too low. This will distort the level and slope of yield curve immediately after the announcement.

(b): Two or three years in the future will see a more stabilized yield curve as the interest rates will stabilize at lower rates. This is because the long term rates are not so much affected by the actions of the Fed and intervention of the Fed as much as the short term rates are affected. The yield curve will remain downward sloping though as there will be little expectations for interest rates to increase in future.