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For all questions be sure to show your work and/or explain your reasoning! Market for LT Bonds CP ic The above diagram depicts the equilibrium CP(interest risk) and quantity in the market for long- term bonds. Here R represents the long-term interest rate that would prevail in a pure expectations world. Answer the following questions based on the information in the diagram and explain your reasoning a. Can you say whether the yield curve slopes up or down? (That is whether long rates are higher or lower than short rates.) b. How would your answer to (a) change if you knew that everyone expected short-term rates to remain unchanged in the future? c. Do more borrowers or more lenders "naturally" to prefer long term bonds. d. In the actual equilibrium that results, are there more borrowers or more lenders in the long- term bond clientele?

Explanation / Answer

The yield curve or the term structure of interest rates, is a graph that plots the yields of same quality bonds against their maturities, ranging from shortest to longest. With the help of this curve investors compare the yields offered by short term, medium term and long term bonds.

a) Here the yield curve slopes downwards as long term interest rate is lower than that of short term.

Reason: If short term yields are higher than long-term yields, the yield curve slopes downwards, then the curve is referred to as an inverted or negative yield curve.

b) If short term interest rates remain unchanged or there is no difference between short term and long term yields, the yield curve is flat. It is a sign that the economy is moving towards recession. When inflation fear also comes up with the fear of recession, investors will buy long term bonds to capture higher yields. This causes prices of these bonds to appreciate and their yields to move down closer to short term rates, resulting in a flattened yield curve.

c) Investors will borrow money to buy more long term bonds if the point b. above prevails.

d) In the equilibrium, there are more borrowers in the economy for buying the long term bonds.

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