Suppose the yield curve is initially horizontal.Suppose the current one-year interest rate increases by 4% while the expected future one-year interest rate does not change.Which of the following will tend to occur?

Question

Quizplus · Accepted Answer

If the yield curve is initially horizontal and the current one-year interest rate increases by 4%, then the yield curve will become upward sloping. However, since the expected future one-year interest rate does not change, this means that the slope of the yield curve will be less than 45 degrees. This indicates that the increase in the current one-year interest rate will not be fully reflected in the two-year interest rate. Therefore, the i2t will increase by less than 4%, and since the expected future one-year interest rate does not change, i2t will increase by 2% (which is less than the increase in the current one-year interest rate). Therefore, the correct answer is B) i2t will increase by 2%.

Suppose the Yield Curve Is Initially Horizontal