Friday, September 18, 2009

policy Implications of the expectations hypothesis

The expectations hypothesis has important implications for public policy. The theory clearly implies that changes in the relative amounts available of long-term versus short-term securities do not influence the shape of the yield curve unless investor expectations also are affected. For example, suppose the U.S. Treasury decided to refinance $100 billion of its maturing short-term IOUs by issuing $100 billion in long-term bonds. Would this government action affect the shape of the yield curve? Certainly, the supply of long-term bonds would be significant increased, while the supply of short-term securities would be sharply reduced. However, according to the expectations theory, the yield curve itself would be unchanged unless investors altered their expectations about the future course of short-term interest rates.
To cite one more example, the Federal Reserve System buys and sells U.S. government and federal agency securities almost daily in the money and capital markets in order to promote the nation‘s economic goals. Can the Fed influence the shape of the yield curve by buying one maturity of securities and selling another? Once again, the answer is no, unless the Federal Reserve can influence the interest-rate expectations of investors. Why? The reason lies in the underlying assumption of the unbiased expectations hypothesis: investors regard all securities, whatever their maturity, as perfect substitutes. Therefore, the relative amounts of long-term bonds versus short-term securities simply should not matter to investors

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