The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.

Question

Quizplus · Accepted Answer

The expectations theory indeed suggests that the shape of the yield curve is determined by the market's expectations of future inflation rates. Specifically, if investors anticipate an increase in inflation in the future, they will demand higher yields for longer-term bonds to compensate for the erosion of the purchasing power of their principal and interest payments. This, in turn, leads to a steepening of the yield curve. Conversely, if inflation is expected to decrease, the opposite occurs, and the curve flattens or even inverts.

The Expectations Theory Postulates That the Term Structure of Interest