Question

Following a policy meeting on March $19,2009$the Federal Reserve made an announcement that it would purchase up to $\$300$billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

Short answer

As the yield curve became less steep, the interest rate on long-term Treasury securities fell.

Step-by-step solution

Definition

The yield curve shows the relationship between various interest rates and the period of maturity of bonds having the rest of the terms of the contract the same. The yield curve can be slanted upwards, flat, or downwards.

Explanation

Suppose the federal reserve decides to purchase up to $\$300$billion long-term Treasury securities over the following six months. As a result, the supply of government securities decreases, as seen below:

The supply of treasury securities decreases, shifting S_T to S_T' as shown. This changed the equilibrium in the market for Treasury securities from point A to point B and increased the price to P'. Remember that an asset's price and interest rate are inversely connected. This means that the interest rate for these longer-term securities has fallen as a result of the federal reserve's decision.

This would cause the yield curve to be less steep because the interest on longer-term Treasury securities fell. This change is illustrated below.