Why is it in News?
Yield curve in the US has inverted for the first time since mid 2007- a shift that has in past signaled recession.
What is the Yield Curve?
- Yield curve is a plot between rate of interest earned on the bonds on Y axis and maturity period on the X axis.
- Under normal circumstances there is proportional relationship between interest rate on bonds and its maturity period i.e. short term bonds have low interest rate while long term bonds have high interest rate
Breaking this Concept further:
- Say at this instant health of the economy is sound, so the Government of the day will not pay high interest rate on the bonds which it issues for short term, but no one knows what will happen to the economy in long terms (say 50 years later), so it is generally seen that the interest rate is higher on long term bonds and lower on the short term bonds.
Graphical Representation of a Yield Curve:
Normal Yield CurveInverted Yield Curve
Under a normal yield curve, it is apparent that when the maturity period is less, interest rate is less. When the maturity period is long, the interest rate is more on the bond but it is reversed in the case of an inverted yield curve.
What happened in the US?
- Government securities of US for 3 months maturity is paying the interest rate of 2.46%, while for 10years it is paying the interest rate of 2.44%, which is opposite to the normal trend (ideally it shall be more for long duration bonds).
- Hence, it is evident that a yield curve is inverted in the case of US and inverted yield curve points to recession in the future.
- This curve explains correlation between tax rate and tax revenues.
- It states that if tax rates are very high, reducing them up to a point optimizes tax revenues as it will lead to lesser evasion and better compliance.
Some Deductions from Curve:
1. If we are to the right of T*, if tax rate decreases, tax revenue will increase.
2. If we are to the left of T*, if tax rate decreases, tax revenue will decrease.