Inflation, Income Taxes, and the Rate of Interest: a Theoretical Analysis

Total Page:16

File Type:pdf, Size:1020Kb

Inflation, Income Taxes, and the Rate of Interest: a Theoretical Analysis This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Inflation, Tax Rules, and Capital Formation Volume Author/Editor: Martin Feldstein Volume Publisher: University of Chicago Press Volume ISBN: 0-226-24085-1 Volume URL: http://www.nber.org/books/feld83-1 Publication Date: 1983 Chapter Title: Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis Chapter Author: Martin Feldstein Chapter URL: http://www.nber.org/chapters/c11328 Chapter pages in book: (p. 28 - 43) Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis Income taxes are a central feature of economic life but not of the growth models that we use to study the long-run effects of monetary and fiscal policies. The taxes in current monetary growth models are lump sum transfers that alter disposable income but do not directly affect factor rewards or the cost of capital. In contrast, the actual personal and corporate income taxes do influence the cost of capital to firms and the net rate of return to savers. The existence of such taxes also in general changes the effect of inflation on the rate of interest and on the process of capital accumulation.1 The current paper presents a neoclassical monetary growth model in which the influence of such taxes can be studied. The model is then used in sections 3.2 and 3.3 to study the effect of inflation on the capital intensity of the economy. James Tobin's (1955, 1965) early result that inflation increases capital intensity appears as a possible special case. More generally, the tax rates and saving behavior determine whether an increase in the rate of inflation will increase or decrease steady-state capital intensity. The analysis also shows that the net real rate of interest received by savers may be substantially altered by the rate of inflation. Section 3.3 Reprinted by permission horn American Economic Review 66 (December 1976): 809-20. I am grateful to the University of California at Berkeley for the opportunity to prepare this paper while I was Ford Research Professor. The National Science Foundation sup- ported the project on the effects of fiscal programs on capital accumulation and income distribution, of which the current study is a part. I am grateful for discussions with Stanley Fischer, Steven Goldman, and David Hartman. 1. Income taxes have been studied in nonmonetary growth models by Peter Diamond (1970,1975), Feldstein (1974a, b), and Kazuo Sato (1967). Of course, the effects of inflation cannot be examined in such models. 28 29 Inflation, Income Taxes, and the Rate of Interest discusses the desirability of adjusting the taxation of interest income to eliminate these arbitrary effects of inflation. The fourth section discusses the implications of this for the welfare effects of inflation and the optimal rate of growth of the money supply. 3.1 A Growing Economy with Inflation and Income Taxes This section presents a one-sector neoclassical model of economic growth with inflation and income taxes. The model differs from that of Tobin (1965) in two fundamental ways: (1) the savings rate depends on the net real rate of return earned by savers; (2) there are personal and corporate interest income taxes as well as a lump sum tax.2 Because the analysis of the model in section 3.2 will focus on comparative steady-state dynamics, only these steady-state properties will be discussed here. The steady-state economy will be characterized by an inflation rate ir = Dp/p and a nominal interest rate of /. The real rate of interest is, by definition, r = / - TT . In order to consider the effects of adjusting the tax treatment for the rate of inflation, separate tax rates will be specified for the real and inflation components of the nominal rate of interest. The personal income tax will tax real interest payments at 6X and the inflation component at 82. The net nominal rate of return is thus iN - (1 - 6J r + S0 (1 - 82)TT. In our current tax law Q1 = Q2 ^^iN = (1 ~ &)(? + IT) = (1 - Q)i. With complete inflation indexation, 62 = 0 and iN = (1 - O^r + IT; the net real rate of interest received by households is thus rN = iN - TT = (1 - e^r. The economy is characterized by an exogenously growing population (1) N The labor force is a constant fraction of the population. Production can be described by an aggregate production function with constant returns to scale. The relation between aggregate output per capita (y) and aggre- gate capital stock per capita (k) is (2) y=f{k) with /' > 0 and /" < 0. For simplicity, both technical progress and depreciation are ignored. 3.1.1 The Demand for Capital The investment and financing behavior of firms is influenced by the corporate income tax. An important feature of the corporation tax is that the interest paid on corporate debt may be deducted by firms in calculat- ing taxable profits while dividends paid on corporate equity may not be 2. In the more general model of David Levhari and Don Patinkin, the savings rate does depend on the rate of return but there are no corporate or personal income taxes. 30 Inflation and Tax Rules in Macroeconomic Equilibrium deducted. Although the method of finance need not affect the analysis in models without a corporate income tax, it is necessary in the current model to identify the method of finance. Because the focus of the current paper is on the effect of inflation on the rate of interest, I will assume that all corporate investment is financed by issuing debt.3 The tax deduction of interest payments may also be adjusted for inflation: let J1 be the tax rate at which the real component of interest payments is deducted and let T2 be the tax rate at which the inflation component can be deducted. The net 4 rate of interest paid by firms is then (1 - T^r + (1 - T2)TT. In the absence of the corporation tax, the firm maximizes its profit by investing until the marginal product of capital is equal to the real rate of interest, i - TT. Stated somewhat differently, the firm's capital stock is optimal when the marginal product of capital [/'(&)] plus the nominal appreciation in the value of the capital stock per unit of capital (ir) is equal to the nominal rate of interest: (3) /'(*) +IT = i The effect of the corporation tax on this optimality condition depends on the way that depreciation is treated by the law. Consider first the simple case in which capital lasts forever, i.e., in which there is no depreciation. The corporation tax then reduces the net-of-tax marginal product of capital to (1 - ^/'(k). There is no tax on the unrealized appreciation of the capital stock. The firm maximizes profits by increasing the capital stock until the net nominal return on capital (1 — Ti)f'(k) + TT is equal to the net nominal rate of interest, (1 — J{) r + (1 — T2)TT. The first-order optimum of equation (3) therefore becomes (4) f'{k) = r- TT 1-Ti If the capital stock does depreciate, f'{k) can be interpreted as the marginal product of capital net of the cost of replacing the capital that has been used up in production. If the corporation tax allows the deduction of 3. It would, of course, be desirable to have a more general model in which corporate debt and equity coexist. The exclusion of equity in the current analysis and the full deductibility of corporate interest payments imply that the present value of corporation taxes is zero. The present model might therefore be regarded as an approximation to a model in which equity profits are intramarginal and all marginal investments are financed by debt (see Joseph Stiglitz 1973). Dale Henderson and Thomas Sargent (1973) studied the effect of inflation in an economy in which firms finance all investment by issuing equity. Because they use a short-run analysis with no accumulation of capital, their conclusions cannot be compared with those of the current analysis. After this paper was accepted for publication, Jerry Green, Eytan Sheshinski, and I (1978; chap. 4 below) developed a more general extension of the current analysis in which firms use an optimal mix of equity and debt finance. 4. In steady-state growth with fully anticipated inflation there is no need to distinguish between short-term debt and long-term debt. 31 Inflation, Income Taxes, and the Rate of Interest the replacement cost of this depreciation, the net-of-tax marginal product of capital is again (1 - T\)f'{k) and equation (4) continues to hold. I will use this condition to describe the demand for capital.5 3.1.2 Liquidity Preference The real value of household assets is the sum of the real values of outside money (M/p) and corporate bonds (B/p): Since outside money bears no interest, the ratio of money to bonds that households will hold is a decreasing function of the after-tax nominal rate of return on bonds, iN = (1 - 8x)r + (1 - 82)^. The real value of bonds (B/p) is also the real value of the capital stock (K). The liquidity prefer- ence relation can therefore be written in per capita terms as (6) f = L[(l - eOr + (1 - 62H,L'<0 where m = M/pN, the real money balances per capita. In steady state, mlk must remain constant. Equivalently, M/pK remains constant, i.e., the rate of growth of M is equal to the rate of growth of pK or TT + n.
Recommended publications
  • Measuring the Natural Rate of Interest: International Trends and Determinants
    FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Measuring the Natural Rate of Interest: International Trends and Determinants Kathryn Holston and Thomas Laubach Board of Governors of the Federal Reserve System John C. Williams Federal Reserve Bank of San Francisco December 2016 Working Paper 2016-11 http://www.frbsf.org/economic-research/publications/working-papers/wp2016-11.pdf Suggested citation: Holston, Kathryn, Thomas Laubach, John C. Williams. 2016. “Measuring the Natural Rate of Interest: International Trends and Determinants.” Federal Reserve Bank of San Francisco Working Paper 2016-11. http://www.frbsf.org/economic-research/publications/working- papers/wp2016-11.pdf The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Measuring the Natural Rate of Interest: International Trends and Determinants∗ Kathryn Holston Thomas Laubach John C. Williams December 15, 2016 Abstract U.S. estimates of the natural rate of interest { the real short-term interest rate that would prevail absent transitory disturbances { have declined dramatically since the start of the global financial crisis. For example, estimates using the Laubach-Williams (2003) model indicate the natural rate in the United States fell to close to zero during the crisis and has remained there into 2016. Explanations for this decline include shifts in demographics, a slowdown in trend productivity growth, and global factors affecting real interest rates. This paper applies the Laubach-Williams methodology to the United States and three other advanced economies { Canada, the Euro Area, and the United Kingdom.
    [Show full text]
  • Interest Rates and Expected Inflation: a Selective Summary of Recent Research
    This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Explorations in Economic Research, Volume 3, number 3 Volume Author/Editor: NBER Volume Publisher: NBER Volume URL: http://www.nber.org/books/sarg76-1 Publication Date: 1976 Chapter Title: Interest Rates and Expected Inflation: A Selective Summary of Recent Research Chapter Author: Thomas J. Sargent Chapter URL: http://www.nber.org/chapters/c9082 Chapter pages in book: (p. 1 - 23) 1 THOMAS J. SARGENT University of Minnesota Interest Rates and Expected Inflation: A Selective Summary of Recent Research ABSTRACT: This paper summarizes the macroeconomics underlying Irving Fisher's theory about tile impact of expected inflation on nomi­ nal interest rates. Two sets of restrictions on a standard macroeconomic model are considered, each of which is sufficient to iniplv Fisher's theory. The first is a set of restrictions on the slopes of the IS and LM curves, while the second is a restriction on the way expectations are formed. Selected recent empirical work is also reviewed, and its implications for the effect of inflation on interest rates and other macroeconomic issues are discussed. INTRODUCTION This article is designed to pull together and summarize recent work by a few others and myself on the relationship between nominal interest rates and expected inflation.' The topic has received much attention in recent years, no doubt as a consequence of the high inflation rates and high interest rates experienced by Western economies since the mid-1960s. NOTE: In this paper I Summarize the results of research 1 conducted as part of the National Bureaus study of the effects of inflation, for which financing has been provided by a grait from the American life Insurance Association Heiptul coinrnents on earlier eriiins of 'his p,irx'r serv marIe ti PhillipCagan arid l)y the mnibrirs Ut the stall reading Committee: Michael R.
    [Show full text]
  • ADM-505 How to Determine Interest Rates
    How to Determine Pre- & Post- Judgment Interest Rates in 2021 1. Is there a contract that sets the interest rate? If not, go to #2. 2. Is there a statute other than AS 09.30.070 that sets the interest rate? 1 If not, go to #3. 3. When did the cause of action accrue? 2 a. Before August 7, 1997: Both the pre- & post- judgment interest rates are 10.5%3 b. On or After August 7, 1997: Both pre- & post- judgment interest rates will be the interest rate for the year in which the judgment is entered.4 For judgments entered in 2021, this rate is 3.25%.5 Note: After the interest rate on a particular judgment is established, it does not later change, even though the interest rate changes. For example: The post-judgment interest rate on a judgment entered in 2001 is 9%. That rate will stay 9% until the judgment is paid. It is not affected by the fact that new judgments entered in 2021 will have a 3.25% interest rate. 1 Examples of other statutes that set interest rates: • AS 25.27.025 – child support arrearages • AS 06.05.473(h) – claims upon liquidation of a state bank • AS 09.55.440(a) – compensation for property taken in eminent domain proceeding • AS 13.16.475(d) – claims against decedent’s estate 2 Accrue. In general, a cause of action “accrues” when a suit may be maintained thereon, that is, when sufficient events have occurred to support a valid lawsuit (for example, when injury or damage occurs or when a contract is breached).
    [Show full text]
  • Fact Sheet on Interest Rate Restrictions
    Federal Deposit Insurance Corporation FACT SHEET Interest Rate Restrictions The Federal Deposit Insurance Corporation (FDIC) published a final rule to revise its regulations relating to interest rate restrictions on banks that are less than well capitalized. PROMOTES FLEXIBILITY AND RESPONSIVENESS ACROSS ECONOMIC CYCLES – The final rule promotes flexibility for institutions subject to the interest rate restrictions and ensures that those institutions will be able to compete for deposits regardless of the interest rate environment. • The final rule defines the “National Rate Cap” as the higher of (1) the national rate plus 75 basis points; or (2) for maturity deposits, 120 percent of the current yield on similar maturity U.S. Treasury obligations and, for nonmaturity deposits, the federal funds rate, plus 75 basis points. • By establishing two methods for calculating the national rate cap, the FDIC ensures that deposit interest rate caps are durable under both high-rate or rising-rate environments and low-rate or falling-rate environments. MORE COMPREHENSIVE NATIONAL RATE – The final rule defines the National Rate to include credit union rates for the first time. • “National Rate” is defined as the weighted average of rates paid by all IDIs and credit unions on a given deposit product, for which data are available, where the weights are each institution’s market share of domestic deposits. PROMOTES TRANSPARENCY – The final rule calculates the National Rate Cap based on similar maturity U.S. Treasury obligations and the federal funds rate, which are both publicly available, and thus, represent a more transparent calculation for bankers and the public. REDUCES REGULATORY BURDEN – The final rule provides a new simplified process, as opposed to the current two-step process, for institutions that seek to offer a competitive rate when the prevailing rate in an institution’s local market area exceeds the national rate cap.
    [Show full text]
  • The-Great-Depression-Glossary.Pdf
    The Great Depression | Glossary of Terms Glossary of Terms Balanced budget – Government revenues equal expenditures on an annual basis. (Lesson 5) Bank failure – When a bank’s liabilities (mainly deposits) exceed the value of its assets. (Lesson 3) Bank panic – When a bank run begins at one bank and spreads to others, causing people to lose confidence in banks. (Lesson 3) Bank reserves – The sum of cash that banks hold in their vaults and the deposits they maintain with Federal Reserve banks. (Lesson 3) Bank run – When many depositors rush to the bank to withdraw their money at the same time. (Lesson 3) Bank suspensions – Comprises all banks closed to the public, either temporarily or permanently, by supervisory authorities or by the banks’ boards of directors because of financial difficulties. Banks that close under a special holiday declaration and remained closed only during the designated holiday are not counted as suspensions. (Lesson 4) Banks – Businesses that accept deposits and make loans. (Lesson 2) Budget deficit – When government expenditures exceed revenues. (Lesson 4) Budget surplus – When government revenues exceed expenditures. (Lesson 4) Consumer confidence – The relationship between how consumers feel about the economy and their spending and saving decisions. (Lesson 5) Consumer Price Index (CPI) – A measure of the prices paid by urban consumers for a market basket of consumer goods and services. (Lesson 1) Deflation – A general downward movement of prices for goods and services in an economy. (Lessons 1, 3 and 6) Depression – A very severe recession; a period of severely declining economic activity spread across the economy (not limited to particular sectors or regions) normally visible in a decline in real GDP, real income, employment, industrial production, wholesale-retail credit and the loss of overall confidence in the economy.
    [Show full text]
  • Philip R Lane: Determinants of the Real Interest Rate
    SPEECH Determinants of the real interest rate Remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the National Treasury Management Agency Dublin, 28 November 2019 Introduction It is a pleasure to address the Annual Investee and Business Leaders’ Dinner organised by the National Treasury Management Agency (NTMA).[1] I plan today to explore some of the factors determining the evolution of the real (that is, inflation-adjusted) interest rate over time. This is obviously relevant to the NTMA in its role as manager of Ireland’s national debt and also to its other business areas (Ireland Strategic Investment Fund; State Claims Agency; NewEra; National Development Finance Agency) and related entities (National Asset Management Agency; Strategic Banking Corporation of Ireland; Home Building Finance Ireland). More generally, the real interest rate is at the core of many financial valuation models, while simultaneously acting as a fundamental macroeconomic adjustment mechanism by reconciling desired savings and desired investment patterns. My primary focus today is on the real interest rate on sovereign bonds, which in turn is the baseline for pricing riskier bonds and equities through the addition of various risk premia. The real return on government bonds in advanced economies has undergone pronounced shifts over time. Chart 1 shows that, since the 1980s, the real return on sovereign debt has registered a steady decline towards levels that are low from a historical perspective. Looking at the 1970s, ex-post calculations of the real interest rate were also low during this period, since inflation turned out to be unexpectedly high.
    [Show full text]
  • Macro-Economics of Balance-Sheet Problems and the Liquidity Trap
    Contents Summary ........................................................................................................................................................................ 4 1 Introduction ..................................................................................................................................................... 7 2 The IS/MP–AD/AS model ........................................................................................................................ 9 2.1 The IS/MP model ............................................................................................................................................ 9 2.2 Aggregate demand: the AD-curve ........................................................................................................ 13 2.3 Aggregate supply: the AS-curve ............................................................................................................ 16 2.4 The AD/AS model ........................................................................................................................................ 17 3 Economic recovery after a demand shock with balance-sheet problems and at the zero lower bound .................................................................................................................................................. 18 3.1 A demand shock under normal conditions without balance-sheet problems ................... 18 3.2 A demand shock under normal conditions, with balance-sheet problems ......................... 19 3.3
    [Show full text]
  • Deflation: Economic Significance, Current Risk, and Policy Responses
    Deflation: Economic Significance, Current Risk, and Policy Responses Craig K. Elwell Specialist in Macroeconomic Policy August 30, 2010 Congressional Research Service 7-5700 www.crs.gov R40512 CRS Report for Congress Prepared for Members and Committees of Congress Deflation: Economic Significance, Current Risk, and Policy Responses Summary Despite the severity of the recent financial crisis and recession, the U.S. economy has so far avoided falling into a deflationary spiral. Since mid-2009, the economy has been on a path of economic recovery. However, the pace of economic growth during the recovery has been relatively slow, and major economic weaknesses persist. In this economic environment, the risk of deflation remains significant and could delay sustained economic recovery. Deflation is a persistent decline in the overall level of prices. It is not unusual for prices to fall in a particular sector because of rising productivity, falling costs, or weak demand relative to the wider economy. In contrast, deflation occurs when price declines are so widespread and sustained that they cause a broad-based price index, such as the Consumer Price Index (CPI), to decline for several quarters. Such a continuous decline in the price level is more troublesome, because in a weak or contracting economy it can lead to a damaging self-reinforcing downward spiral of prices and economic activity. However, there are also examples of relatively benign deflations when economic activity expanded despite a falling price level. For instance, from 1880 through 1896, the U.S. price level fell about 30%, but this coincided with a period of strong economic growth.
    [Show full text]
  • The Essential JOHN STUART MILL the Essential DAVID HUME
    The Essential JOHN STUART MILL The Essential DAVID HUME DAVID The Essential by Sandra J. Peart Copyright © 2021 by the Fraser Institute. All rights reserved. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. The author of this publication has worked independently and opinions expressed by him are, therefore, his own, and do not necessarily reflect the opinions of the Fraser Institute or its supporters, directors, or staff. This publication in no way implies that the Fraser Institute, its directors, or staff are in favour of, or oppose the passage of, any bill; or that they support or oppose any particular political party or candidate. Printed and bound in Canada Cover design and artwork Bill C. Ray ISBN 978-0-88975-616-8 Contents Introduction: Who Was John Stuart Mill? / 1 1. Liberty: Why, for Whom, and How Much? / 9 2. Freedom of Expression: Learning, Bias, and Tolerance / 21 3. Utilitarianism: Happiness, Pleasure, and Public Policy / 31 4. Mill’s Feminism: Marriage, Property, and the Labour Market / 41 5. Production and Distribution / 49 6. Mill on Property / 59 7. Mill on Socialism, Capitalism, and Competition / 71 8. Mill’s Considerations on Representative Government / 81 Concluding Thoughts: Lessons from Mill’s Radical Reformism / 91 Suggestions for Further Reading / 93 Publishing information / 99 About the author / 100 Publisher’s acknowledgments / 100 Supporting the Fraser Institute / 101 Purpose, funding, and independence / 101 About the Fraser Institute / 102 Editorial Advisory Board / 103 Fraser Institute d www.fraserinstitute.org Introduction: Who Was John Stuart Mill? I have thought that in an age in which education, and its improvement, are the subject of more, if not of profounder study than at any former period of English history, it may be useful that there should be some record of an education which was unusual and remarkable.
    [Show full text]
  • Simple Interest Problems
    Simple Interest Problems Interest is money paid for the use of money. If you borrow from the bank to buy a car, the bank will charge you interest for its use. If you open a savings account at the bank, the bank will pay you interest for as long as the account is open. Note: Banks usually charge compound interest not simple interest. See your local accounting teacher for more information. The interest (I) is the dollar amount earned or owed. The interest rate (R) is per year (T) unless otherwise noted. Note: If the time is in months, T can be found using the ratio number of months . 12 The principal (P) is the amount borrowed or deposited. This is the formula to express simple interest: I(nterest) = P(rincipal) x R(ate) x T(ime) I = P x R x T or I = PRT Solve each of these interest problems: 1) You get a student loan from the New Mexico Educational Assistance Foundation to pay for your educational expenses this year. Find the interest on the loan if you borrowed $2,000 at 8% for 1 year. (You may wish to use the percent key on your calculator or change 8% to .08) 2) You are starting your own small business in Albuquerque. You borrow $10,000 from the bank at a 9% rate for 5 years. Find the interest you will pay on this loan. Simple Interest Problems Revised @ 2009 MLC page 1 of 2 3) You are tired at the end of the term and decide to borrow $500 to go on a trip to Whatever Land.
    [Show full text]
  • On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation
    BPEA Conference Drafts, March 7–8, 2019 On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation Łukasz Rachel, LSE and Bank of England Lawrence H. Summers, Harvard University Conflict of Interest Disclosure: Lukasz Rachel is a senior economist at the Bank of England and a PhD candidate at the London School of Economics. Lawrence Summers is the Charles W. Eliot Professor and President Emeritus at Harvard University. Beyond these affiliations, the authors did not receive financial support from any firm or person for this paper or from any firm or person with a financial or political interest in this paper. They are currently not officers, directors, or board members of any organization with an interest in this paper. No outside party had the right to review this paper before circulation. The views expressed in this paper are those of the authors, and do not necessarily reflect those of the Bank of England, the London School of Economics, or Harvard University. On falling neutral real rates, fiscal policy, and the risk of secular stagnation∗ Łukasz Rachel Lawrence H. Summers LSE and Bank of England Harvard March 4, 2019 Abstract This paper demonstrates that neutral real interest rates would have declined by far more than what has been observed in the industrial world and would in all likelihood be significantly negative but for offsetting fiscal policies over the last generation. We start by arguing that neutral real interest rates are best estimated for the block of all industrial economies given capital mobility between them and relatively limited fluctuations in their collective current account.
    [Show full text]
  • Interest Rate Expectations and the Slope of the Money Market Yield Curve
    Interest Rate Expectations and the Slope of the Money Market Yield Curve Timothy Cook and Thomas Hahn l What determines the relationship between yield This paper surveys the recent literature on the and maturity (the yield curve) in the money market? determinants of the yield curve. It begins by review- A resurgence of interest in this question in recent ing the expectations theory and recent empirical tests years has resulted in a substantial body of new of the theory. It discusses two general explanations research. The focus of much of the research has been for the lack of support for the theory from these tests. on tests of the “expectations theory.” According to Finally, the paper discusses in more detail the the theory, changes in the slope of the yield curve behavior of market participants that might influence should depend on interest rate expectations: the more the yield curve, and the role that monetary policy market participants expect rates to rise, the more might play in explaining this behavior. positive should be the slope of the current yield curve. The expectations theory suggests that vari- I. ation in the slope of the yield curve should be THE EXPECTATIONS THEORY systematically related to the subsequent movement Concepts in interest rates. Much of the recent research has focused on whether this prediction of the theory is Two concepts central to the tests of the expecta- supported by the data. A surprising finding is that tions theory reviewed below are the “forward rate parts of the yield curve have been useful in forecasting premium” and the “term premium.” Suppose an in- interest rates while other parts have not.
    [Show full text]