Suppose there are two types of bonds (one- year bonds and two- year bonds) and that the yield curve is initially upward sloping in period t. For this question assume that: (1) expected inflation is zero; and (2) the relevant interest rate on the vertical axis of the IS- LM model is the one- year interest rate. Based on our understanding of the IS- LM model, of the yield curve and of financial markets, we know with certainty that an announcement in period t of a partially unexpected future increase in taxes (to be implemented in period t + 1) will have which of the following effects?
A) Stock prices will fall in period t.
B) The yield curve will become steeper in period t.
C) Stock prices will increase in period t.
D) The yield curve will become flatter in period t.
E) Stock prices will not change in period t.

Question

Quizplus · Accepted Answer

An announcement of a partially unexpected future increase in taxes will cause a shift in the IS curve to the left due to a decrease in consumption spending, leading to a decrease in the equilibrium interest rate in period t. The decrease in the one-year interest rate will be greater than the decrease in the two-year interest rate due to the longer maturity of the two-year bond. This will lead to a flatter yield curve in period t. Therefore, the correct answer is D.

Suppose There Are Two Types of Bonds (One- Year Bonds