Support for the addition of a liquidity premium to the expectations theory is derived from:
A) the slope of the observed normal yield curve is steeper than that of expectation theory.
B) the slope of the observed normal yield curve is flatter than that of expectation theory.
C) the liquidity premium decreases over time.
D) in times of tight monetary policy an inverse yield curve becomes more inverse.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that longer-term bonds carry a liquidity premium to compensate investors for the additional risks associated with time, such as interest rate risk and inflation risk. This premium causes the observed yield curve to be steeper than what the expectations theory alone would predict, as it only accounts for future interest rates without considering the liquidity premium.

Support for the Addition of a Liquidity Premium to the Expectations