Leading economists have predicted that the Federal Reserve will continue to pursue a stable monetary policy that has characterized the last five years, keeping the price level constant into the future. Given the Fed's monetary policy, the pure expectations theory and the liquidity preference theory would predict, respectively, the following yield curve shapes:
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A. B. C.Explanation
Based on the information provided, the question asks about the predicted yield curve shapes under the assumption of the Federal Reserve's stable monetary policy and the theories of pure expectations and liquidity preference.
Therefore, based on the prediction that the Federal Reserve will continue to pursue a stable monetary policy and keep the price level constant, the pure expectations theory would predict a flat yield curve. This means that the yields on short-term, medium-term, and long-term bonds would be relatively similar.
Under normal conditions, an upward-sloping yield curve is commonly observed. This means that longer-term bonds have higher yields compared to shorter-term bonds. The rationale behind this shape is that investors demand a higher yield as compensation for holding longer-term bonds and tying up their funds for a longer period.
However, if the Federal Reserve is expected to maintain a stable monetary policy, which implies stable short-term interest rates, the liquidity preference theory would predict a flat yield curve. This is because if short-term rates are expected to remain constant, investors would have no reason to demand higher yields on longer-term bonds. Therefore, the yields on all maturities would be relatively similar, resulting in a flat yield curve.
To summarize, based on the assumptions of the Federal Reserve's stable monetary policy and the theories of pure expectations and liquidity preference, the predicted yield curve shapes would be:
A. Flat and flat.