Suppose that financial market participants now expect a future tax increase in one year. Also assume that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

(a) the yield curve will become steeper

(b) i2t will increase

(c) i2t will decrease

(d) the yield curve will become downward sloping

(e) the yield curve will be the same

For our macroeconomics class, we learn LM curve as the flat line, where the interest rate it totally up to the central bank, so I thought (e) might be the answer. However, I cannot really tell the relationship between the tax and yield curve. I can tell that increase in tax will shift IS curve to left, but how does it will affect the yield curve?

Also, I cannot tell the difference between the choice (a) and (b). Isn't the yield curve being steeper the same as the increase in a 2-year interest rate? Thanks a lot!

  • $\begingroup$ 1) A more specific title would help. Something like the “relationship between a tax increase and the yield curve.” 2) There’s a real world answer, and a textbook answer. Ideally, you would specify the model to use. I have a good idea of the real world answer, but not the textbook. 3) Yield curve steeper = 2 down, 10 up. $\endgroup$ – Brian Romanchuk Oct 4 '20 at 13:07

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