Abstract

The Importance of Price Expectations for the Term Structure of Interest Rates

This article explains the term structure of interest rates on the basis of the equilibrium on the market for fixed-interestbearing securities. First, a microeconomic explanation of the supply of and demand for long and short term bonds is given, using the portfolio theory approach. The individual market participant makes his decision on the issue as far as the maturity is concerned by maximizing his utility function. Ihe respective arguments are the mean and varıance of the probability distribution of portfolio yıelds, which in turn are dependent on the mean and variance of the anticipated future short-term interest rate. Tihe anticipated interest rate is explained on the basis of the price expectations. The microeconomic supply and demand functions are then aggregated. With allowances being made for the market equilibrium condition, this enables the interest structure to be explained. This hypothesis is subsequently tested empirically with data for the Federal Republic of Germany. The quantitative results permit a statement on the degree of money illusion in the years from 1969 to 1971.