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MAF 202 Yield Curve Prospects with Economy Assignment Solution
Yield Curve is a vital indicator of the economic conditions of a nation. There can be differences or changes in the slope of the yield curve with the changes in the interest rates, which can be interest rates for long term loans or interest rates for short term loans. The interest rates are fixed by the monetary authorities of a nation. This will be based on the monetary policy. Therefore, it is essential to formulate and implement a proper monetary policy in a country. This policy may make changes in the in order to increase or decrease the long term and short term interest rates. This is usually done for the purpose of ensuring a good economic development of the country. The changes in the interest rates will be seen in the yield curve. The different slopes of the yield curve will be an indication of whether the economy is slowing down or rising up. In this essay writing, we examine how the changes in the slope of the yield curve will affect the economic development of a nation. It is also seen how the monetary policy is affected in response of the economic or financial stress and its level of impact on the yield curve (Estrella, A., & Mishkin, F., 1998).
Yield curve is a curve which helps to know the yields or interest rates in different contract periods say, 4 months, 4 years, 40 years etc in the same debt contract. Through this curve, one will come to know the relationship between the interest rate and the maturity period. This is called as a ‘term’ of the debt related to a particular borrower in a particular currency. There are different shapes for a yield curve. Each shape has different indication that denotes the cumulative priorities that a lender will have for a borrower. Considering the rising inflation rate, lenders prefer to offer long term loans with higher rates of interests than short term loans. The term structure of interest rates is called a yield curve. This is the graphical representation of the yields with regard to the similar bonds issued for long term or short term. The investors will get a fair picture of the curve, about the trends by watching the yield curve (Solow, R. M, 1956).
The Yield Curve, December 2009
While considering the yield curve in December 2009, there was a steep in the curve during this time period. This indicates that the long rates are rising up and the short rates are holding a steady position. This difference in the rates is known as the slope of yield curve. When there is an inverted yield curve, wherein the short rates are above the long rates, there is an indication of recession in that particular year. In December 2009, there was a constant rate with a 0.04 per cent. AT this rate, an investment of 100 dollars would reap 4 cents. This shows that the probability of recession in the coming year is low. And the economy has already come out of the recession to an extent.
The Yield Curve, December 2010
With respect to the recent trend, there was a sharp steep of the yield curve during December 2010. This was due to the increase in the long rates up to three tenths of one percent. The short rates were at a steady position. The Treasury bill stayed at the rate of 0.14 per cent. By looking at this trend, the economists suggest that the GDP is expected to grow up to 1.0 per cent rate in the next year. The chances of the economic condition which may lead to recession in the next year was predicted as 1.5 per cent (Estrella, A, 2005).
The Yield Curve, December 2011
There was a huge difference between the yields on two and ten year treasuries since 2011. This was mainly due to more employment in the country and this rose. As a reason of this, the Federal Reserve which was close to the slowing bonds started growing. For the benchmark 10 year notes, the yield came to 255 basic points. For the purpose of security against the risk of inflation, investors sought for a premium that occurs as a result of the faster growth seen in this time period.
The Yield Curve, December 2012
During this period, the difference in the yield in the 5-year treasury rise when there was a drop in the prices. Similarly, the 5-year treasury dropped to 1.90 percent from 2.08 per cent. The trend in the flat yield curve shows that there are expectations that the monetary policy will be made steady by the Federal Reserve when the central bank raises the policy rate.
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The Yield Curve, December 2013
During the year 013, the benchmark treasury 10 year note showed a yield of 2.86 percent. This was a rise by 11 points. It is considered as the longest stretch in the past half year. By December 2013, it reached up to 0.32 percent. This is the highest level since November 2013.
Impact of Yield Curve on Economy
Yield curve is a graphic representation showing the spread between short term and long term interest rates for different bonds like government bonds. The structure and shape of the yield curve has a major impact on the economy of the nation. With the help of the yield curve, one can predict the expected economic changes in the future. This can be even known with the interactions between the monetary policy and how the investors expect on the same. There are differences in the interest rates in the short term loans and long term loans. When there is a situation where the short term loans are of low rate, then that denotes that the economy is in a bad condition and it requires a financial support. However, the market players expect a rise in the interest rates. The expectations of the inflationist’s also vary. The expectations of the inflationist’s increases, the long term interest rates will have been included with a risk premium. This risk premium will be higher than the short term interest rates. In order to know the economic condition and the expected economic growth of the country, the economists rely on the yield curve. This is the probable reason as to why there is an increase in the long term interest rates than the short term interest rates. As an indication of this, the yield curve will show an upward slope. When the economy is not at its peak and is having a slow growth, this is indicated by an inverted yield curve. This shows that the short term rates may come down in the future. There is a huge correlation between the yield curve and the monetary policy. The effect of both of these has a high impact on the economy of Australian and United States. The short term interest rates are fixed by the central bank. Therefore, they have a significant role in the changes in the shape of the yield curve. According to the changes in the shape of the yield curve, the monetary authorities also react differently. The monetary authorities will react to the economy of the country only when there are significant changes in the economy. For small changes or fluctuations is the economy, they usually will not changes the rates in the short term loans. The rates are revised only when there is any considerably high issue happens to the economy. In such cases, they will increase the interest rates of the short term loans.
Short Term US T-Bills
Impact of monetary policy in the changes in yield curve and economy
Monetary policy is the policy implemented by the central monetary authority in order to control the supply of money in the economy. The main objective of a monetary policy is to ensure the economic growth by targeting a particular interest rate. This can be long term interest rates or short term interest rates. By controlling on the monetary policy, there will be more stability, control on inflation, a reduction in the unemployment and so many other benefits to the nation. The monetary policy can be of two types, one is expansionary and the other is contractionary. In expansionary policy, there will be increase in the total supply of money in the economy. This will be in a faster pace than in the usual way. This type of policy is framed when there is more unemployment rate in the economy and this has to be reduced. By implementing this policy especially in the time of the recession, through reducing the interest rates will help to recover the economic downfall of the nation through increased unemployment. This policy has a main motive that, by lowering the interest rates, there will be an easy availability of the credit to the business entities. As a result of this, they can ensure their expansion at an easier pace at the time of the adverse economic conditions (Ang, A., Piazzesi, M., & Wei, M, 2006). Through the possibility of more expansion to a business organization, there can be an increase in the economic growth in the country through the reduction of unemployment. This is possible as more people will get jobs through business firms increased operations. Moreover, this policy will also invite more foreign business entities to come and flourish in the nation and expands its business here. This will bring more Foreign Direct Investment (FDI) to the nation. This will contribute to the economic development of the nation.
In a contractionary policy, the money supply will be expanded at a slower pace and even shrinks it. This policy is usually formulated at the time of inflation, in order to reduce the inflation affecting the country. This is because; inflation will result in distortions and deterioration of asset values. The monetary policy has a great influence on the yield curve also (Wright, J. H, 2006). When the monetary policy is tightened, this denotes to the rise in the short term interest rates. The central authorities implement such a tightened monetary policy in order to reduce the issues and economic crisis related to the inflation and its pressures. As the pressure reduces by a period of time, there will be ease in the monetary policy. In this scenario, low interests rates will be applied back once again. At the time of tightened monetary policy, long term interest rates rise comparatively at a lesser pace than short term interest rates (Bernanke, B. S., & Reinhart, V. R, 2004). The monetary authorities had a tightening cycle which started since June 2004. There are certain key notable respects in this concern. Firstly, there was a delay in its onset more than what was expected by many observers. The policy was kept hold for an unusual period of time by FOMC. The primary motive of this act was to enable a better economic expansion so that it is protected against any kind of risk that may occur due to inflation happened in 2003 and this effect may result in deflation. Such a situation is a critical aspect that affects the economy of the nation and also on the efficiency of the monetary policy. One of the main factors of concern is to avoid inflation, whether it is too high or too low. Another unusual experience that happens recently is the extent to which policy actions changed in advance. This is one of the factors that caused the tightening cycle. At the time of the cycle, after each meeting of FOMC, a statement was issued that had qualitative guidance about how the monetary policy will be evolved in the future and what is its impact on the economic condition of the nation. By knowing the expected path of the policy, there will be no increase in the long term interest rates and the current market prices that may lead to the tightening cycle. As a result of the monetary tightening, the economy will slow down and the yield curve will be flattened (Kim, C. J., & Nelson, C. R, 1999).
At the stage of conclusion, it is noted that the yield curve and monetary policy play significant roles in the economic conditions of a nation. It is seen that the effective implementation of monetary policy by the central authorities help in the economic growth of the country. The monetary policies are to be tightened and there has to be less supply of money in the economy at the time of inflation so as to reduce the deterioration of the fixed assets. Doing so by the policy makers, the economic growth of the nation can be ensured. When there are more unemployment and issues related to the business expansion, the monetary policies are to be formulated in such a way so that there is enough supply of money in the economy ensuring an ease in getting the employment opportunities in an increased pace and more business expansion. This will lead to economic growth. Yield curve also has a huge linkage with the economic development. If there is lower interest rate for the short term loans formulated by the central monetary authorities, then this is the indication of slow economic growth and vice versa. Thus it can be concluded that a thorough study of the yield curve will help to know the economic conditions of a nation. The control on the economic crisis can be initiated through an effective monetary policy, by controlling the supply of money in a proper way according to the prevailing economic condition (Diebold, F. X., Rudebusch, G. D., & Boragan Aruoba, S, 2006).
- Estrella, A., & Mishkin, F. S. (1998). Predicting US recessions: financial variables as leading indicators. Review of Economics and Statistics, 80(1), 45-61.
- Ang, A., Piazzesi, M., & Wei, M. (2006). What does the yield curve tell us about GDP growth?. Journal of Econometrics, 131(1), 359-403.
- Solow, R. M. (1956). A contribution to the theory of economic growth. The quarterly journal of economics, 70(1), 65-94.
- Kim, C. J., & Nelson, C. R. (1999). Has the US economy become more stable? A Bayesian approach based on a Markov-switching model of the business cycle. Review of Economics and Statistics, 81(4), 608-616.
- Estrella, A. (2005). Why Does the Yield Curve Predict Output and Inflation?*.The Economic Journal, 115(505), 722-744.
- Wright, J. H. (2006). The yield curve and predicting recessions. Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board.
- Bernanke, B. S., & Reinhart, V. R. (2004). Conducting monetary policy at very low short-term interest rates. American Economic Review, 85-90.
- Diebold, F. X., Rudebusch, G. D., & Boragan Aruoba, S. (2006). The macro economy and the yield curve: a dynamic latent factor approach. Journal of econometrics, 131(1), 309-338.
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