What happens to the shape of the yield curve if, ceteris paribus, expectations about future interest rates change such that future short term interest rates are expected to be higher than previously expected?
A)the slope (shape) of the yield curve remains the same but the curve shifts up.
B)the differences among various yield curves narrows.
C)the yield curve becomes steeper.
D)Both a and b are correct.

Question

Quizplus · Accepted Answer

If future short term interest rates are expected to be higher than previously expected, this implies that the market expects a tighter monetary policy in the future. This would lead to an increase in the yields of short term bonds. In comparison, long term bond yields are less affected by short term interest rate expectations, so they will remain relatively stable or even decrease. As a result, the difference between short term and long term bond yields, known as the yield spread, will widen, making the yield curve steeper. Therefore, choice C is the best answer.

What Happens to the Shape of the Yield Curve If