Suppose that financial market participants now expect a future tax cut and that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

Question

Quizplus · Accepted Answer

If financial markets expect a future tax cut, this suggests an increase in economic growth and demand for credit, causing interest rates to rise. As a result, the yield curve will become steeper as the difference between short-term and long-term interest rates widens. This is consistent with the expectations theory of the yield curve. Choice A is incorrect because a vertical yield curve would suggest that there is no difference between short-term and long-term interest rates, which is unlikely. Choice C is incorrect because a U-shaped yield curve is associated with an inverted yield curve, which typically occurs during economic recessions. Choice D is incorrect because a horizontal yield curve would imply that interest rates remain constant across all maturities, which is also unlikely. Choice E is incorrect because a flatter yield curve would suggest that the difference between short-term and long-term interest rates is decreasing, which goes against the expectations theory.

Suppose That Financial Market Participants Now Expect a Future Tax