Expectations and Liquidity preference theory Flashcards
What is expectations theory
Observed long-term rate is a function of today’s short-term rate and expected future short-term rates
The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds.
Long-term and short-term securities are perfect substitutes
Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates
Formula and problems with expectations theory
Fn = E(Rn) and liquidity premiums are zero
A common problem with using the expectations theory is that it sometimes overestimates future short-term rates, making it easy for investors to end up with an inaccurate prediction of a bond’s yield curve.
Another limitation of the theory is that many factors impact short-term and long-term bond yields. The Federal Reserve adjusts interest rates up or down, which impacts bond yields, including short-term bond
Types of yield curve
Rising - yields on short term rates are low and rise consistently with longer maturities
Declining - Yields of short term issues are high and yields on longer maturities decline
Flat - has approx equal yields on short and long term issues
Humped - yields on intermediate term issues are above those on short term issues and rates on long term issues decline to levels below those for short-term
Liquidity preference theory
Long term bonds are riskier, and investors will demand a premium for the risk associated with long-term bonds therefore f exceeds E(Rn) as it is more sensitive to interest rate change
The excess f is the liquidity premium
Yield curve
The yield curve has an upward bias built into the long-term rates because of the liquidity premium an upward sloping curve could indicate that rates are expected to rise, or investors require large liquidity premiums
Liquidity premium and econ conditions (liquidity preference)
Forward rates thus contain a liquidity premium and are not equal to expected future short-term rates
Long term rates tend to rise in anticipation of economic expansion
Economic conditions like recessions that create uncertainty raise liquidity preference as people wish to remain more liquid. This requires higher interest rates to induce a shift to illiquid assets. The liquidity preference theory thus views interest rates as emerging from people’s desire for liquidity versus illiquid, interest-earning assets. The more liquidity is preferred, the higher the rate required to overcome that preference
Three motives of liquidity
Keynes
Transaction motive – hold cash for buying goods
Precautionary motive: buffer against emergency’s
Speculative – take advantage of future investment oppurtunities not yet available
Objections of liquidity preference
One common objection is that many complex factors, not just liquidity preference, determine interest rates. The approach is also said to simplify changes in interest rates to just the demand and supply of money.
Further, the empirical evidence for the impact of liquidity preference on interest rates is mixed. Some economists argue other factors like inflation expectations play a bigger role in shaping rate changes.
Measuring liquidity preference quantitatively is also difficult.
