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environment, it would give economic agents more certainty about the future and better expectations of growth. Moreover, the government would be free to focus on the existing bottlenecks (wage and price rigidity) which prevent actual output to be closer to the potential one.

Price stability does not mean stability of the real interest rate.  Price stability may moderate nominal interest rate fluctuations but does not eliminate them.  Interest rate changes are still needed to offset the inherent tendency towards cyclicality in many market economies (see chapter 16 for further details).

Q5 When the fiscal implications of German unification in 1990 became apparent, the yield curve steepened. Explain why this should have happened.

Interest rates differ according to the maturity of the loan. There are short term bonds (usually less than one year), medium, and long term bonds (for example a 10 year government bond). The curve representing the relationship between the time to maturity and the interest rates of bonds with different time-profile is called yield curve. Yields are represented in nominal terms and usually the shape of the curve is upward sloping, as in figure 13.2. The shape is determined by the following factors:

i) Time preferences. Consumption this year is better than the promise of the same consumption next year which, in turn, is better than the same consumption in 5 or 10 year time. To compensate for the longer wait, people are remunerated with higher interest rates.

ii) Higher risk.  An investment over 10 year time is more uncertain than an investment over 6 months.  To compensate for the higher risk, interests are higher.

iii) Expected inflation.  Besides these real factors, also expectations about future inflation must be taken into account.  Expectations lie behind the possibility that the yield curve might have also different shapes, for example being upward- or downward-sloping.  If economic agents expect higher inflation in the future, they will require a higher nominal interest in the long term; if they expect inflation to fall, they will require a lower rate of interest.

With respect to the German case, let us assume that before the reunification the yield curve was flat (because of expectations of price stability).  After 1991, the costs of reunification became clear - more unemployment and more spending for social welfare. Moreover, the decision to exchange eastern marks in western marks with a 1:1 ratio increased the real cost of labour (due to lower productivity in eastern regions) and boosted real money supply. In other words, in re-unified Germany both fiscal deficit and money supply increased, creating the perfect conditions to expect a revival of inflation.  To compensate for higher risks and to offset the impact of future expected inflation, nominal interests had to rise more than proportionately in the long term, thus implying a steeper yield curve. In figure 13.2, yield curve moved from y1 to y2 after the reunification.


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