Under the liquidity preference theory, if the yield curve is flat, we can most likely conclude that: A. Short-term interest rates are expected to fall. B. Short-term interest rates are expected to remain at the same level. C. Short-term interest rates are expected to rise.
Answer is A. Why? I picked B because short-term rates would equal long-term rates if the yield curve is flat.
Liquidity preference assumes that there is a (positive) liquidity premium, increasing as maturity increases. If the yield curve is flat, then the curve with the liquidity preference slopes downward. As the yield curve evolves, the lower (underlying, without the liquidity premium) forward rate will become the spot rate.
Simply put: the liquidity preference theory assumes higher reward the longer the maturity. Hence, the curve should always be positively sloped.
If that’s not the case (flat curve, or even negatively sloped) we can either expect ST rates to fall or LT rates to rise. Since the options only consider ST rates, A is the correct answer.
If the yield curve’s flat or inverted, why would you expect long-term rates to rise? That makes no sense.
The Andreavespa’s reasoning alignes with mine. Liquidity preference theory is not capable of explaining inverted or downward sloping yield curves. That’s how the market segmentation and the preferred habitat theories evolved.
short tem rates + liquid premium = long term rates. So if yield curve is flat (long term rates are same as they are in short term) so it means short term rates are falling.