The Types of Yield Curves and Their Effects on the Economy - Example

BUSINESS REPORT Date: Department: Subject: Address: Dear This is the report that has been prepared in the analysis of the various shapes of yield curved for the developed economies. The two countries covered in this report are Australia and Norway. These are the leading countries with a stable economy in the world. The main purpose of this report is to explore the effects of higher interest rates on the economy because of the frequent changes in the yield curves. Interest rates and monetary policy have been fully covered, and their effect on the yield is also analyzed. This is a well-researched report and its content have been collected from the reliable sources. I hope the report will be of a great value to you. Respectfully yours Name: Executive Summary The shape of the yield curves is vital since it helps the investors to make decisions on when to invest. Through yield curves, economist can easily predict the future of the economy. Besides, the yield curve can be used in selecting the effective monetary policy when handling a problem of inflations. Monetary policy is an instrument which can be used to stabilize economic conditions in the country. It controls various issues such as inflation, fluctuating interest rates, high prices in the country and unstable exchange rates. Table of Contents Executive Summary 2 Introduction 4 Yield curve analysis 4 Similarities in the two economies 5 Types of yield curves 5 1.Normal yield curve 5 2.Flat yield curve 5 3.Inverted yield curve 6 4.Humped yield curve 6 Australia- overall analysis 6 Norway- overall analysis 7 Indicators of Economy 7 Monetary policy 9 Monetary policy and the exchange rates 9 i.Bank rate policy 10 ii.Cash reserve ratio 11 iii.Open market operation 11 Expansionary monetary policy 12 Conclusion 12 References 14 Appendices 15 Introduction In Most countries, market forces are the determinant of the price controls. This is usually referred to as free market economy. Most developed countries such as Norway control their economies through market forces. However, the shape of yield curves is vital factors because foreign investors use them as indicators of the future economy of the country. This report will analyze all types of yield curves and their effects on the economy. Yield curve analysis Norwegian and Australian economy is among the most developed in the world. The two countries have diverse natural resources that attract a high volume of foreign investments. Furthermore, these countries have a well-established industry that has facilitated high growth of their economy. Some of the common industries in these two countries comprise of food processing, chemicals and natural gas industries. However, their performance varies depending on the nature of the industry. This has resulted to different yield curves that reflect the interest rates in the two countries. Investors use the yield curves to get the vital information on rates of interest, the nature of the economy and inflation. Similarities in the two economies The economy of these two countries is stable. This is because of well-established industries and political stability. Many investors across the world are attracted to these countries. Types of yield curves There are various yield curves in every economy. Some of them comprised of: 1. Normal yield curve Norway and Australia experienced the same yield curve in the period of 2009 and 2011 December. Both of these two economies experienced normal yield curve. In this curve, short term investments are likely to earn less income as compared to long term investments. This difference is usually caused by the uncertainties of inflations, changes in interest rates and future possibilities of economic recession. 2. Flat yield curve This is a situation whereby the interest rates are stable, and the returns on investments tend to be predictable. Economically, the earnings for investing in long term bonds are almost equal to investing in the short term bonds. Such a situation is normally experienced when the central bank is trying to contain the inflations. Besides, the country can experience such when there is an economic slowdown. Australia and Norway have not experienced this because of their stable economies. These two countries have always experienced budget surplus and a stable Balance of Payment. They are in position of achieving all the required resources because of the huge investments from foreign investors. The diagram for this curve is shown in the appendix diagram …iii 3. Inverted yield curve The inverted yield curve was not experienced in Norway nor Australia between 2009 and 2011 December. Such a situation can only be experienced when the yields on short term bonds are higher than those of long term bonds. The inverted yield curve is the predictor of future recession. This diagram is shown in appendix diagram …ii 4. Humped yield curve This can also be called bell-shaped curves. It happens when the returns in the medium term investments are higher than short and long term investments. Such a situation has never been seen in Norway or Australia. Australia- overall analysis According to the diagram in the appendix below, yield curve was steep at 2010 and this was the indication that the bank should adjust their balance sheet. This was done through borrowing short term loans and lending long term loans. Another strategy that was required was to buy government securities so that they can increase the money supply in the public. This trend in the year 2011 made many investors invest in long term bonds in expectation that the returns were going to be high. The diagram reflecting this situation is shown in appendix diagram ..i Norway- overall analysis There was a world crisis in the 2008 that almost affected the economy of Norway. The economy was affected slightly but because of high manufacture of petroleum products and the shipping that is done in Norway. Thus, the economy of the country is stable. The yield curve that reflects the operating interest rates in Norway were stable. The diagram reflecting the above statement is shown in the appendix diagram …i From 2009 to 2011, the inflation rate in the country has been improving, and this has attracted more investors to invest in the long term investments. According to Vitek, Norway has always attracted foreign investors due to its political stability. The country is one of the most peaceful in the world. Indicators of Economy The shape of the yield curve is vital for decision making. Investors rely on this because it can predict the future of the economy. The most useful feature at this situation is the slope of the yield curve. To be accurate in predicting, economist can construct a yield curve by taking the return on a long term investment minus the short investments. Depending on the nature of the slope, it is essential for investors to know the following key issues. 1. The upward sloping yield curve suggests that the economy is likely to improve in the future. It can also suggest that the Federal Reserve policy is attempting to regulate the economy through the use of rates and market forces. This behavior is acceptable for the economy because it attracts more investment both within the country and outside the country. More investments mean that the country will be able to earn more foreign currency that will strengthen the value of the local currency. 2. The downward sloping curve suggests that the Federal Reserve policy is likely to increase the rates on short term investments. This in most cases is not practical because many economies depend on the market forces. It is, however, necessary in a situation where the economy is performing poorly. In stable economies, this problem can easily be corrected as compared to developing countries. 3. The flat or inverted curves are not appropriate for the economy. This is an indicator for the coming of the recession. In this situation, short term rates tend to be higher than those of long term rates. This discourages the investors and most of them will resort to invest in other countries. This is dangerous for the economy because the gold reserve for the country will go down. Furthermore, the country will face various problems such as borrowing funds, problems of inflation, and poor Balance of Payment. Monetary policy Monetary policy is the key tools that are used to influence an economy. They are extremely effective and are used to catalyze the growth of aggregate demand. These tools are also used to regulate the supply of money in an economy. In comparison with the fiscal policy, monetary policy is more powerful especially when there is a need to regulate the rate of inflation. Besides, the monetary policy can be used in monitoring the value of exchange rates. This is a vital role because fluctuation of the currency is not suitable for an economy. Incomes, output, and prices are among the key features in an economy, and this can be affected by the fluctuation of the currency. When the short term interest rates are altered, the effect is always felt by the economy. The spending, savings behavior of household and business can be affected since the flow of money will tend to move in either side depending on the nature of interest rates. Monetary policy and the exchange rates All the developed countries have no official exchange rate to target. Most of the countries use a free floating exchange rate because of its effectiveness. The system is beneficial especially in controlling the movement of interest rates. This will also control the bank lending rate depending on the amount of money in circulation. Central banks are the only institutions that are responsible in controlling inflation through monetary measures. Most of them apply the traditional way of raising interest rates so as to reduce bank lending. When lending rate high, people will be discouraged from borrowing or taking loans from banks and, therefore, the amount of money in the hands of the public will reduce. The monetary policy tools are discussed below: i. Bank rate policy The central banks use this policy to regulate the amount of money in which the commercial bank can borrow. When a central bank raises the rate of lending to other banks the amount of money held by a commercial bank reduces. This will force the commercial to reduce the amount they lend to borrowers. Investors will benefit from this because the rate of inflation will reduce and thus the returns on investments will increase. The yield curve shape will move upwards indicating higher returns per investments. The few people that have cash will benefit especially in buying government securities or treasury bills. The returns are high because few are willing to buy and thus the prices are low. ii. Cash reserve ratio This tool reduces the amount of money held by banks in the country. This normally happens when commercial banks are required to increase the amount of the deposit they make at a central bank. The effect of this tool is extensive because it will affect the price of goods and services in the country. Increase in cash reserve ratio will cause the yield curve to move, temporarily, inverted, and this can discourage investments. However, the effect is a short term, and with time the yield curve will change. This means that investors will be affected slightly as compared with the bank. iii. Open market operation Central banks use this tool to discourage commercial banks from creating credit to customers. This process is done through selling of government securities to the public. Securities are always attractive to the public, and many people are willing to buy them. The effect of open market operation on the shape of the yield curve depends on the situation of the market. For example, if the rates offered on short term and long term are impeccably associated through the mechanism that was expected then there will be no effect on debt management policy. When using this tool many factors need to be put into consideration. Some of the factors to be considered are the influence arising from domestic treasury bills foreign treasury bills. In some cases, the two bills can be perfect substitutes thus maintaining the same situation. Expansionary monetary policy Depending on the country, the expansionary monetary policy can be applied in the following ways; i. Purchasing of government securities from the public ii. Lowering the federal discount rate iii. Lower the amount of required reserves All the above strategies increase the amount of money in circulation. This happens because the above measures can lead to an increase in prices of bond and at the same time it lowers the interest rates. When the interest rates are lowered , many people will go for loans so that they can invest in various available opportunities. This policy has a positive impact on the investors and the policy makers. Investors will tend to invest in the countries because stable exchange rates. Furthermore, the investors will be certain of the future because devaluation of the currency are not likely to be experienced. The policy makers will experience a positive balance of payment because exports will be higher as compared to imports. In such a case, there will be high inflows of foreign currency than the outflows. Conclusion In conclusion, monetary policy works in two different ways. It depends on how it is applied; sometimes it can be contractionary or expansionary depending on the objective of the central bank. In either of the situation, the policy affects the amount of money in circulation. Contractionary monetary policy reduces the amount of money in circulation while the expansionary increases the amount of money in circulation. References Appendices Diagram………..i 5 4 3 2 1 Diagram……ii Diagram …iii Read More