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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

Which development would most plausibly cause the Indian government bond yield curve to flatten, with long yields falling relative to short yields?

A credible policy rate rise that lowers long-term inflation expectations flattens the curve, because short yields increase while long yields fall or stay steady. The other options raise long yields or term premiums, which steepens the curve.

  1. AMarkets expect inflation to rise sharply and persistently over the next decade
  2. BThe central bank raises policy rates and signals credibility in bringing inflation down, lowering long-term inflation expectationsCorrect
  3. CThe government announces a large increase in long-dated bond issuance with no change in demand
  4. DInvestors move out of long bonds into short-term deposits because of liquidity needs
  5. The term premium on long bonds rises

Explanation

Higher short rates lift the short end, while credible inflation control reduces long-run inflation expectations and long yields, so the curve flattens. The other options push long yields up or leave the short end unchanged, which steepens the curve.

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