THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 162

130 PA R T I I Financial Markets short-term interest rates are expected to stay the same on average in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward How can the liquidity premium and preferred habitat theories explain the occasional appearance of inverted yield curves if the liquidity premium is positive? It must be that at times short-term interest rates are expected to fall so much in the future that the average of the expected short-term rates is well below the current short-term rate Even when the positive liquidity premium is added to this average, the resulting long-term rate will still be below the current short-term interest rate As our discussion indicates, a particularly attractive feature of the liquidity premium and preferred habitat theories is that they tell you what the market is predicting about future short-term interest rates just from the slope of the yield curve A steeply rising yield curve, as in panel (a) of Figure 6-6, indicates that short-term interest rates are expected to rise in the future A moderately steep yield curve, as in panel (b), indicates that short-term interest rates are not expected to rise or fall much in the future A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future Finally, Yield to Maturity Yield to Maturity Term to Maturity Term to Maturity (a) Future short-term interest rates expected to rise (b) Future short-term interest rates expected to stay the same Yield to Maturity Yield to Maturity Term to Maturity (c) Future short-term interest rates expected to fall moderately FIGURE 6-6 Term to Maturity (d) Future short-term interest rates expected to fall sharply Yield Curves and the Market s Expectations of Future Short-Term Interest Rates According to the Liquidity Premium and Preferred Habitat Theories