THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 162

130

PA R T I I

Financial Markets
short-term interest rates are expected to stay the same on average in the future,
long-term interest rates will be above short-term interest rates, and yield curves
will typically slope upward.
How can the liquidity premium and preferred habitat theories explain the
occasional appearance of inverted yield curves if the liquidity premium is positive? It must be that at times short-term interest rates are expected to fall so much
in the future that the average of the expected short-term rates is well below the
current short-term rate. Even when the positive liquidity premium is added to this
average, the resulting long-term rate will still be below the current short-term
interest rate.
As our discussion indicates, a particularly attractive feature of the liquidity
premium and preferred habitat theories is that they tell you what the market is
predicting about future short-term interest rates just from the slope of the yield
curve. A steeply rising yield curve, as in panel (a) of Figure 6-6, indicates that
short-term interest rates are expected to rise in the future. A moderately steep
yield curve, as in panel (b), indicates that short-term interest rates are not
expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future. Finally,

Yield to
Maturity

Yield to
Maturity

Term to Maturity

Term to Maturity

(a) Future short-term interest rates
expected to rise

(b) Future short-term interest rates
expected to stay the same

Yield to
Maturity

Yield to
Maturity

Term to Maturity
(c) Future short-term interest rates
expected to fall moderately

FIGURE 6-6

Term to Maturity
(d) Future short-term interest rates
expected to fall sharply

Yield Curves and the Market s Expectations of Future Short-Term Interest
Rates According to the Liquidity Premium and Preferred Habitat Theories