Abstract
This paper attempts to explain why yield curve inversion may serve as a leading indicator of recessions. It employs an IS-LM model with the term structure of interest rates and provides a formal phase-diagram analysis of dynamic adjustment process. It demonstrates that the occurrence of yield curve inversion is an off-equilibrium phenomenon after an adverse shock in the adjustment process of interest rates and output, and that an inverted yield curve may lead, but does not lead to, a recession.
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Notes
Romer (2008) has shown the equivalence between the two treatments in this regard.
In theory, the interest rate in the money demand function should be the nominal rate. Here, it is converted by Fisher equation, as usual.
Blanchard and Fisher (1989) developed such a model to study the effects of a change in fiscal policy such as the 1981–1983 tax cuts. But they did not explicitly label both the long-term and the short-term interest rates in their graphic analysis; instead, the short-term rate was eliminated and indirectly represented by the long-term rate from the term structure and the Fisher equation. Hence, their treatment did not explicitly present yield curve in the picture.
Note that the driving force behind the term structure of interest rates is arbitrage. Hence, when it is off the structure, the same driving force would apply to pull the long-term rate back to the position as determined by the term structure.
See also, for example, Sydsæter et al. (2005, p. 251).
References
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The authors would like to thank Richard Cebula, Chris Coombs and the audiences in the 72nd International Atlantic Economic Society (IAES) Conference at Washington DC for their comments on earlier versions. Bill Yang is grateful to the Department of Finance and Economics, Georgia Southern University for the research support (Summer 2011). The standard disclaimer applies.
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Wang, X.H., Yang, B.Z. Yield Curve Inversion and the Incidence of Recession: A Dynamic IS-LM Model with Term Structure of Interest Rates. Int Adv Econ Res 18, 177–185 (2012). https://doi.org/10.1007/s11294-012-9350-7
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DOI: https://doi.org/10.1007/s11294-012-9350-7