The Inverted Yield Curve and the Economic Downturn

Abstract

This paper presents an answer to why the yield curve tends to invert one year before a recession. The capital-based macroeconomic model used in this paper traces out the effects of an injection of short-term working capital into the model. There are two consequences of this injection: the Wicksell effect and the Fisher effect. The Wicksell effect entails the downward pressure on interest rates, while the Fisher effect entails the upward pressure on interest rates. The short-term credit can create both short- and long-term malinvestments in the social structure of production. These malinvestments are unsustainable and must be liquidated. The process of liquidation phase may take the form of a credit crunch, a real resource crunch, or a combination of the two. Each scenario culminates in an inverted yield curve approximately one year before the upper-turning point of a recession.