November 11, 2004
The Term Structure of Interest Rates
The relationship between short-term and long-term interest rates depends on the risk of long-term assets. This link is a very important factor in how monetary policy determining short-term interest rates might hope to affect the economy through investment, which depends on long-term interest rates.
The forward rate is a function of short-term and long-term interest rates.
The expectations hypothesis employs very similar algebra. Instead of calculating a forward rate, it assumes agents have an expectation of future short-term interest rates. Competition between short-term and long-term investments should then lead to a link between the current short-term and long-term rates.
The relation between short-term and long-term rates also includes some component that can be called a risk premium. In talking about the yield curve, the entire difference is often call the risk premium.
The risk that most concerns investors in long-term assets is, of course, the risk of inflation. There is no obvious process for distinguishing in the realized interest rates the difference, which long-term rates increase, between an increased risk premium due to the perceived risk of inflation and an increase in long-term rates due to expectations of higher future inflation and, hence, higher future short-term interest rates.
