Question

If inflation is predicted to rise significantly in the future, what effect would you expect to have on the slope of a normal yield curve? Explain the reasons.

Answer 1

If inflation is predicted to rise significantly in the future, the slope of yield curve would be upward sloping as-

A. Investors will demand a higher yield to counter higher inflation so Yield curve will go upward.

B. Investors expects that future value of bonds will get eroded with rising inflation and hence they demand a higher rate of yield to counter the depreciation in purchasing power.

C. The Investors demand a higher risk premium to invest in such inflationary situations so they demand a higher yield to counter the risk of inflation, hence there is upward sloping yield curve.

So because of the above stated reasons, investors are expecting an increase in yield leading to a upward sloping yield curve.