Which of the following is consistent with a flat yield curve?
A) Monetary policy is restrictive while fiscal policy is expansive. B) Monetary policy is restrictive and fiscal policy is restrictive. C)
Monetary policy is expansive while fiscal policy is restrictive.
Can someone explain this question? Much appreciated, thanks.
both restrictive -> inverted
both expansive -> steep upward
FP Loose, MP tight = flat
MP Loose, FP tight = moderately steep
so A)
Could you explain why the last one leads to a moderately steep curve?
bond yields tend to fall - so yield curves are moderately steep.
From my master in Financial Economics days , Monetary policy overpowers fiscal power. Fiscal policy does have an effect but its a tug of war with monetary policy tilted toward monetary policy being loose or tight. Now relate this to the yield curve shapes in the CFAI text
Monetary policy maintains price stability by increasing or decreasing the short term interest rate. Fiscal policy, on the other hand, impacts the long term interest rates.
When the Central bank increases interest rates (restrictive policy), this will have an immediate impact on the short-term interest rates. If at the same time the government increases government spendings (expansive policy), this will increase the expectation in the future economic conditions and the long term interest rates will increase. The yield curve will be only moderately steep due to the counterintuitive effect of the both policies.
You can remember the environment for a flat yield curve with the below Mnemonic:
" FEM u R"
F iscal: E xpansive, M onetary: R estrictive
Get it… your femur is flat.
Imagine a short active guy named monetary policy on the left and a tall lazy guy named fiscal policy on the right, each holding one end of a rope (interest rate curve) that nominally goes up from left to right.
The short guy likes to jump up and down and his side of the rope moves up and down a lot. Which is why, if MP is tight and FP is tight, the yield curve rises and flattens.