Effect of Monetary and Fiscal Policy on Yield Curve

CFA Level III Economics
#1

Jimbo says that a flat yield curve is consistent with tight monetary policies and tight fiscal policies.

Jimbo’s statement is:

  1. correct.
  2. incorrect with regard to monetary policy.
  3. incorrect with regard to fiscal policy.

Solution:

C A flat yield curve is consistent with tight monetary policy and loose fiscal policy, which means that Jimbo’s statement is incorrect with regard to fiscal policy

My take on this:

I perfectly understand that tight monetary policy will raise short rates and since long rates typically don’t respond to short term CB policy the curve flattens.

BUT, I don’t understand the effect of fiscal policy. IF the government is loosening policy, that is spending more money, it borrows more money, and long term yields go up (since more bonds are issued, and the people need to be incetivized to buy them with higher rates), thus making the curve steeper, right?

#2

Tartaglia,

It helps me to think back to Level II with the Mundell-Flemming Capital Mobility:

Monetary/Fiscal Policy High Capital Mobility Low Capital Mobility

Expansionary/Expansionary Uncertain Depreciate

Expansionary/Restrictive Depreciate Uncertain

Restrictive/Expansionary Appreciate Uncertain

Restrictive/Restrictive Uncertain Appreciate

Basically, if the government has conflicting monetary and fiscal policies then the implications of the yield curve are not as clear. Here are my notes for Econ for Level III on this topic:

  • If both are stimulative, the yield curve is steep and the economy is likely to grow. → STRONG FUTURE ECONOMY
  • If both are restrictive, the yield curve is inverted and the economy is likely to contract. → WEAK FUTURE ECONOMY
  • If monetary is restrictive and fiscal is stimulative, the yield curve is flat and the implications for the economy are less clear.
  • If monetary is stimulative and fiscal is restrictive, the yield curve is moderately steep and the implications for the economy are less clear.

Your thinking regarding monetary policy is right. Hope this helped.

#3

You are saying the implication for the yield curve are not clear, but you have said in case 3 that the yield curve is flat. That is exactly what I am not understanding. Let’s go through each case, and you can correct me where I am wrong:

  1. mon policy (MP) is stimulative and fiscal policy (FP) are stimulate the curve steepens. Why is that? Because short end is getting lower and long end is getting higher (b/c goverment is borrowing more money so it can stimulate the economy, that sends rates higher).

  2. Bot restrictive, short end goes up, long end stays where it is (since the government is not borrowing more money to stimulate, it does not supply more bonds). yield curve might even invert as you said.

  3. MP restrictive, FP is stimulate, short end goes up, but long end goes up too (since the government is borrowing money) so depending on which effect dominates, it could go either way

  4. MP stimulative (short end goes down) but FP restrictive, then long end remains the same, and I agree we should see some steepening.

So case 3 seems to be where we disagree, I would argue, that is does not necessarily get steeper.

I think you are right though about Mundel Fleming offering an answer(from Wiki). In both cases, the effect I described above of how the interest rates rise, is reversed in the end.

Open Economy

An increase in government expenditure shifts the IS curve to the right. This will mean that domestic interest rates and GDP rise. However, this increase in the interest rates attracts foreign investors wishing to take advantage of the higher rates so they demand the domestic currency therefore it appreciates. The strengthening of the currency will mean it is more expensive for domestic producers to export so net exports will decrease therefore cancelling out the rise in government spending and shifting the IS curve to the left. Therefore the rise in government spending will have no effect on the national GDP or interest rate.

closed economy:

Increased government expenditure shifts the IS curve to the right. The shift results in an incipie nt rise in the interest rates. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currency using domestic funds in order to shift the LM curve to the right. In the end, the interest rate stays the same but the general income in the economy increases.

#4

Mark it