Liquidity Preference Theory Yield Curve

This means that long-term interest rates are an unbiased predictor of future expected short-term rates. If long-term interest rates are determined solely by current expectations of future rates, then an upward sloping yield curve would imply that investors expect short-term rates to rise in the future. Because under normal conditions, the yield curve does indeed slope upward, this further implies that investors consistently seem to expect short-term rates at any given point in time. Each of the different theories of the term structure has certain implications for the shape of the yield curve as well as the interpretation of forward rates. The five theories are the unbiased expectations theory, the local expectations theory, the liquidity preference theory, the segmented markets theory, and the preferred habitat theory.

People will sell bonds to prevent losses if bond values are predicted to fall, i.e., if the interest rate is expected to rise. Assume there is a sudden expectation of lower interest rates in the future. Suppose that some events have no effect on expected interest rates, but raises uncertainty about rates. In the context of finance, explain why the height of the yield curve depends on inflation. Explain why a consensus has developed that countries should either allow their exchange rates to float freely or adopt a hard peg as an exchange rate regime.

The second question is relevant when assessing to what extent monetary policy can be blamed for causing the crisis, notwithstanding if it was reasonable from an ex ante perspective. The credit growth and the housing boom in the United States and elsewhere were very powerful. Real interest rates were low to a large extent because of global imbalances, and the global saving glut and investment shortage. I believe that somewhat higher interest rates would have made little or no difference.

The Term Structure of Interest Rates¶

The size of the liquidity premium may also be time-varying. Unbiased expectations theory or pure expectations theory argues that it is investors’ expectations of future interest rates that determine the shape of the interest rate term structure. Under this theory, forward rates are determined solely by expected future spot rates.

The impossible trinity has become self-evident for most academic economists. Today, this insight is also shared by practitioners and policy makers alike. A lingering challenge is that, in practice, most countries rarely face the binary choices articulated by the trilemma. Instead, countries chose the degree of financial integration and exchange-rate flexibility.

Implications of the Theories¶

Fiscal policy is a powerful tool to respond to a liquidity trap, but its use depends on a negative spillover to foreign markets, and generating large terms of trade depreciation. In an asymmetric liquidity trap, exchange rate targeting on the part of foreign authorities may significantly reduce the impact of fiscal policy, and reverses the sign of the international spillover. Finally, when monetary pre-commitment is absent, fiscal policy expansion is essential to an optimal policy response to a liquidity trap. But there little benefit from a jointly coordinated fiscal expansion. In a purely symmetric world equilibrium, the optimal individual country fiscal response to a liquidity trap is identical to that which would obtain in a closed economy.

In simple terms, the liquidity preference theory implies that investors prefer and will pay a premium for more liquid assets. In other words, they will demand a higher return for a less liquid security and will be willing to accept a lower return on a more liquid one. Thus, the liquidity preference theory explains the term structure of interest rates as a reflection of the higher rate demanded by investors for longer-term bonds. The higher rate required is a liquidity premium that is determined by the difference between the rate on longer maturity terms and the average of expected future rates on short-term bonds of the same total time to maturity. Forward rates, then, reflect both interest rate expectations and a liquidity premium which should increase with the term of the bond. This explains why the normal yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little.

The preferred habitat theory suggests that bond investors are willing to buy bonds outside of their maturity preference if a risk premium is available. Yet this does not actually seem to be the case, and it is not clear why they would, or why they would not eventually adjust their expectations once proven wrong. Biased expectations theory is an attempt to explain why the yield curve usually slopes upward in terms of investor preferences. These agents are either unable or unwilling to make any other investment, which is not in line with their maturity preference. The rates are determined by the supply and demand for long-term and short-term debts for the different market segments.

Preferred Habitat Theory (PHT)

Individuals save money to cover the costs of illness, accidents, unemployment, and other unanticipated events. Businessmen must also keep cash on hand to satisfy their immediate demands, such as payments for raw goods, transportation, and labor. The transaction’s motive concerns the want for money or the need for cash in current individual and commercial transactions. Individuals keep cash to bridge the gap between when they receive money and when they spend it. Therefore, this approach gives the liquidity component of investment a lot of weight.

The slope of the yield curve always determines whether forward rates are rising or falling. The desire for liquidity isn’t the only element that influences interest rates. There are a number of other factors that influence interest rates through changes in the demand for and supply of investible funds. This article is about liquidity preference in macroeconomic theory. Suppose that some event takes place which does not affect expected interest rates but does increase uncertainty regarding interest rates. If interest rates are at a level of 1%, and expected inflation is 2%, would you prefer saving or spending your money?

Nature of Business

On the other hand, the speculative motive is interest elastic; it depends on the interest rate. Hence the speculative motive and cash available to satisfy the speculative motive determine the interest rate. According to Keynes, the demand for liquidity is determined by three motives which are, transactional motives, precautionary motives and speculative motives. The Theory of Investment shows the relationship between capital investment and interest rates, demonstrated by a downward sloping Marginal Efficiency of Capital Investment curve. The inverse relationship shows an increase in interest rates leads to a decline in capital investment and a decrease in interest rates leads to a rise in capital investment. Speculative demand is the demand to take advantage of future changes in the interest rate or bond prices.

• The classical or neoclassical theories do not always clash with Keynes’ liquidity-preference hypothesis.
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• An important advantage of the top–down factor allocation process is that if affords the investor an extra degree of freedom in terms of asset allocation.
• A key message of the trilemma is scarcity of policy instruments.
• The theory suggests that an investor earns the same interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today.
• As per this theory, the shape of the yield curve will be based on the period for which funds are invested and the preferences of the investors.

In other words, the interest rate is the ‘price’ for money. The volatility term structure can be measured using historical data and depicts yield curve risk. The sensitivity of a bond value to yield curve changes may make use of effective duration, key rate durations, or sensitivities to parallel, steepness, and curvature movements. Using key rate durations or sensitivities to parallel, steepness, and curvature movements allows one to measure and manage shaping risk. Active bond portfolio management is consistent with the expectation that today’s forward curve does not accurately reflect future spot rates.

Liquidity Preference Theory – Explained

Biased expectations theory has two major variants; liquidity preference theory and preferred habitat theory. Money supply is usually a fixed quantity set by a central banking authority. L is a liquidity preference function if and if , where r is the short-term interest rate and Y is the level of output in the economy.

Therefore, other things remaining constant, https://forexaggregator.com/ and supply of money determine the interest rate. The liquidity preference theory tries to address one of the shortcomings of the pure expectations theory. The theory argues that forward rates also reflect a liquidity premium to compensate investors for exposure to interest rate risk. This liquidity premium is said to be positively related to maturity.

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https://forexarena.net/ – The Market Yield reflects the average of future short-term rates. LOS 28 Explain traditional theories of the term structure of interest rates and describe each theory’s implications for forward rates and the shape of the yield curve. The founder of Keynesian economics and the father of modern macroeconomics, John Maynard Keynes, introduced the theory in his book The General Theory of Employment, Interest, and Money .