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Stop and Think Box  In the nineteenth century, the yield curve was usually flat under normal conditions. FREE BANKING BOOKS (It inverted during  financial panics.) In other words, short-term and long-term bonds issued by the same economic entity did  not often differ much in price. Why might that have been?  One possibility is that there was no liquidity premium then. Then, as now, short-term bonds suffered less  interest rate risk than long-term bonds,{GOOGLEADS} but investors often complained of extremely high levels of FREE BANKING BOOKS PDF reinvestment risk, of their inability to easily and cheaply reinvest the principal of bonds and mortgages when they were repaid. Often, lenders urged good borrowers not to repay (but to continue to service their obligations, of course). Another not mutually exclusive possibility is that the long-term price level stability engendered by the specie standard made the interest rate less volatile. The expectation was that the interest rate would not long stray from its long-term tendency.  The neat thing about this theory is that it reveals the yield curve as the market’s prediction of future  short-term interest rates, making it, by extension, an economic forecasting tool. Where the curve slopes sharply upward, the market FREE BANKING BOOKS DOWNLOAD PDF expects future short-term interest rates to rise. Where it slopes slightly upward, the market expects future short-term rates to remain the same. Where the curve is flat, rates, it is thought, will fall moderately in the future. Inversion of the curve FREE BANKING STUDY MATERIALS means short-term interest rates should fall sharply, as in the numerical example above. The simplest way to BANKING BOOKS 2017-2018 remember this is to realize that the prediction equals the yield curve minus ρn, the term premium. 

Empirical research suggests that the yield curve is a good predictor of future interest rates in the very short term, the next few months, and the long term, but not in between. Part of the difficulty is that ρn is not BANKING STUDY MATERAILS well understood nor is it easily observable. It may change over time and/or not increase much from one maturity to the next on the short end of the curve. Nevertheless, economic forecasters use the yield curve to make predictions about inflation and the business cycle. A flat or inverted curve, for instance, portends lower short-term interest rates in the future, which is consistent with a recession but also with lower inflation rates, as we learned in Chapter 5 "The Economics of InterestRate Fluctuations". A curve sloped steeply upward, by contrast, portends higher future interest rates,  which might be brought about by an increase in inflation rates or an economic boom.  Time once again to ensure that we’re on the same page, er, Web site.

In China’s defense, many developing countries find it advantageous to peg their exchange rates to the dollar, the yen, the euro, the pound sterling, or a basket of such important currencies. The peg, which can be thought of as a monetary policy target similar to an inflation or money supply target, allows the developing nation’s central bank to figure out whether to increase or decrease MB and by how much. A hard peg or narrow band effectively ties the domestic inflation rate to that of the anchor country,  [1] EXAM PREPARATION & TUTORING  instilling confidence in the developing country’s macroeconomic performance.  Indeed, in extreme cases, some countries have given up their central bank altogether and have dollarized, adopting USD or other currencies (though the process is still called dollarization) as their own. No international law prevents this, and indeed the country whose currency is adopted earns seigniorage and hence has little grounds for complaint. Countries that want to completely outsource their monetary policy but maintain seigniorage revenue (the profits from the issuance of money) adopt a currency board that issues domestic currency but backs it 100 percent with assets denominated in the FREE DOWNLOAD FOR PDF anchor currency. (The board invests the reserves in interest-bearing assets, the source of the seigniorage.) Argentina benefited from just such a board during the 1990s, when it pegged its peso one-to-one with the dollar, because it finally got inflation, which often ran over 100 percent per year, under control. {GOOGLEADS} Fixed exchange rates not based on commodities like gold or silver are notoriously fragile, however,  because relative macroeconomic changes in interest rates, trade, and productivity can create persistent  imbalances over time between the developing and the anchor currencies. Moreover, speculators can force countries to devalue (move Epeg down) or revalue (move Epeg up) when they hit the bottom or top of a band. They do so by using the derivatives markets to place big bets on the future exchange rate.