Question

If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve? 

   If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?
The Economics of Money, Banking, and Financial Markets
The Economics of Money, Banking, and Financial Markets
Frederic S. Mishkin 11th Edition
Chapter 6, Problem 20 ↓

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A yield curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the relationship between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.  Show more…

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If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?
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Key Concepts

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Expectations Theory
Expectations theory posits that long-term interest rates are determined by current and expected future short-term interest rates, adjusted for a term premium. This theory explains how shifts in market expectations about short-term rates—such as a sudden decline—directly affect long-term yields and thereby alter the shape of the yield curve.
Slope of the Yield Curve
The slope of the yield curve is the difference between long-term and short-term interest rates. A steep slope indicates a significant difference, often suggesting future economic growth or rising inflation, while a flat or inverted slope can signal economic slowdown or recession expectations. When future short-term interest rate expectations fall, the long-term yields decrease relative to the short-term rates, leading to a flattening of the yield curve.
Yield Curve
The yield curve represents the relationship between the yields on bonds of the same credit quality and different maturities. It provides insights into market expectations of future interest rates, inflation, and economic activity. Changes in the yield curve can signal shifts in these underlying factors and affect investment and borrowing decisions.
Interest Rate Expectations
Interest rate expectations refer to the market's forecast of future short-term interest rates based on economic outlook, monetary policy, and other factors. These expectations are a key driver of long-term interest rates, as investors incorporate anticipated changes into current bond prices and yields.
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