Suppose the economy has an inverted yield curve.According to the Liquidity Premium Theory, which of the following interpretations could be used to explain this?
A)Interest rates are expected to rise in the future.
B)Investors expect an economic slowdown.
C)Investors are indifferent between bonds with different time horizons.
D)The term spread has increased.

Question

Quizplus · Accepted Answer

The Liquidity Premium Theory suggests that long-term bonds carry a premium over short-term bonds because investors expect an economic slowdown or potential default risk. An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates, which indicates that investors expect a recession or economic slowdown. Therefore, choice B is the best explanation. Choices A, C, and D are not consistent with the Liquidity Premium Theory.

Suppose the Economy Has an Inverted Yield Curve