Monetary policy transmission: Impact on the yield curve

Abstract

The intent of the Contemporary Concerns Study (CCS) is to understand the economic concepts revolving around the yield curve and monetary policy transmission. First, the basic understanding about the yield curve, which acts as a link between Macroeconomics and Corporate Finance, will be covered. This would include the types of yield curve namely: normal, inverted, flat and hump, and the factors that capture the movements of the yield curve which include the level (long term factor), slope (short term factor), and the curvature (medium term factor). The theories that help us understand the future yield curve namely: Pure expectations theory, Liquidity preference theory, and Market segmentation theory would be studied in brief. The applications of the yield curve would be covered next and the focus would be primarily upon the predictive power of the yield curve. The paper on “The Yield Curve as a Leading Indicator” by Arturo Estrella and Mary R. Trubin would be used as a reference to understand the application of the yield curve as a leading indicator of future economic activity (American context). Then the data on the yield curve rates and economic activity index for India (1997-2011) would be analyzed to determine the usefulness of the yield curve as a predictor of future economic activity. The next section would cover the linking of the monetary policy transmission and the yield curve. Out of the three components of monetary policy transmission, the bond market would be covered. The mechanism through which the monetary affects the market expectations of the future interest rates and there by impacting the yield curve will be covered. The factors impacting the effectiveness of the monetary policy transmission in the bond market and impact of different monetary policy measures (easing and tightening) on the yield curve at the short end would be explored. Then, a study on the different monetary policy regimes in the Indian context and its implications on the yield curve will be made. The findings and learnings of the CCS would be summarized as part of the conclusion.