If the expectations hypothesis of the yield curve holds, then the government cannot - Essay Example

In December, 2001 the yield on the Treasury notes which were issued for the period of ten years stood at 5.15 percent. The percentile was responsible for the negative change in the long term interest rates during certain periods, however the terrorist attacks conducted on 11th Sept, 2001 created a major impact on the interest rates, and reported a massive downfall in the long term interest rates, which had almost dissipated by the end of the year. The analysts have linked the fluctuating short term and long term interest rates with the reduction in the fund rate, 'by conventional wisdom, reducing the funds rate by the magnitude experienced last year should have had some impact on long term interest rates' (David, 2002).

It is incorrect to associate such a pattern with the ineffectiveness of the monetary policies; rather it is the influence and effectiveness of the monetary policies because of which 'the long rates have failed to budge as short rates have plunged' (David, 2002). The ability and authority of the Central Bank towards providing liquidity, without creating any major impact on the inflation in terms of rise, is the parameter for evaluating the effectiveness of the monetary policy. . In some of the related cases, the coincident features of the economy, which are based on 'the reversals in the stock market, poor corporate earnings, rising unemployment, elevated perceptions of risk' (David, 2002), such situations and conditions are expected to encourage the savers and lenders to move towards such assets which have greater concentration of liquidity, and are based on shorter duration for maturity.

Such situations are expected to 'inevitably drove down short term security yields relative to those on longer term assets' (David, 2002), due to the reason that expectations with reference to the stability of the inflation figures are prominent. These forces are responsible for the generation of an environment in which short rates, including the federal funds rate, decline at massive scale, and have 'relatively little effect on rates at the longer end of the maturity spectrum' (David, 2002). It has been argued that the stability of the inflation figures was based on the lower funds rate.

It is therefore commonly believed that, 'if recession and wobbly confidence have driven interest rates down especially short term rates, recovery and restored confidence will, sooner or later, drive them up' (David, 2002).Yield curve is a basic theory which correlates and interprets the interest rate developments over the past year and what it might offer in the future. The yield curve explains the relation and behavior of the 'returns to securities that differ in terms of the number of months or years in the future that the assets mature, or pay off' (David, 2002).

The curve explains the relation between effects of maturity on interest rates. The Treasury securities operate at default risk, and are