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Another look at yield spreads: Monetary policy and the term structure of interest rates

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  • Kim, Dong-heon

Abstract

Liquidity plays an important role in explaining how banks determine their allocation of funds. This paper analyses whether this fact can explain the term structure of interest rates and yield spreads. The paper models banks' demand for liquidity in a manner similar to that used to study household need for liquidity, namely, by using a cash-in-advance type model. The paper finds that the shadow price of the cash-in-advance constraint plays an important role in determining yield spreads. The model predicts that short-term rates respond more to monetary policy than long-term rates, consistent with earlier empirical findings. The empirical part of the paper shows that the expectations hypothesis might be salvaged under the maintained hypothesis concerning the liquidity premium and default risk premium. This paper confirms the finding that monetary contractions raise nominal interest rates.

Suggested Citation

  • Kim, Dong-heon, 1998. "Another look at yield spreads: Monetary policy and the term structure of interest rates," Research Notes 98-3, Deutsche Bank Research.
    • Handle: RePEc:zbw:dbrrns:983
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    Cited by:

    1. Hamilton, James D & Kim, Dong Heon, 2002. "A Reexamination of the Predictability of Economic Activity Using the Yield Spread," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 340-360, May.

    More about this item

    Keywords

    Term structure of interest rates; Expectations hypothesis; Yield Spreads; Liquidity; Cash-in-advance constraint; Monetary policy;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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