The Term Structure of Interest Rates

THE TERM STRUCTURE OF INTEREST RATES 489
rate structure. Yields on short-term debt average lower than those
on long-term debt because of the advantage of the superior liquidity
of such debt to the holder and the liquidity disadvantage of issuing
such debt to private borrowers. The amount of the liquidity premiums
reflected in the term structure can vary with changes in the
maturity structure of outstanding debt and with other factors affecting
marginal preferences for liquidity in investment assets. Behavior
based upon interest rate expectations is important mainly as a factor
determining very short-run movements in long-term rates. Such
behavior is based mainly on near-term expectations, and is ordinarily
of little importance in determining average rate levels, and relationships,
over considerable periods of time. This theory is summarized
in the following section, and then explored in greater detail.
I. THE ELEMENTS OF TERM STRUCTURE THEORY
The decisions of borrowers and of lenders as to the maturity of
the debt that they create or hold, and the factors underlying them,
determine the relative market valuation of debts of different maturities,
in conjunction with government monetary and debt management
policies. Four major factors underlying the market's relative
valuation of short-term and long-term debt are described in this
section, and explored somewhat further in later sections. These are:
(1) the liquidity difference between long-term and short-term debt;
(2) the attractiveness of debts of different maturities on the basis of
expected future changes in debt prices; (3) short-run effects of
changes in the maturity structure of supply of debt coupled with
rigidities in the maturity structure of demand for it; and (4) differences
in lending costs related to debt maturity.
Short-term debt is more liquid than long-term debt. This fact
compels some lenders to choose short-term debt, and induces others
to prefer it. If there are limitations on the ability or willingness of
debtors to do their borrowing by short-term debt, this factor can
thus result in a marginal lender preference for, and lower yields on,
short-term debt. In fact, it is clear that the ability of private borrowers
to finance their activities by short-term borrowing is subject
to limitations. Average yields on short-term debt lower than those
on long-term debt can be explained, therefore, as representing the
market's marginal evaluation of the superior liquidity of existing
short-term debt. This liquidity premium should be affected by
changes in the maturity structure of debt supplied to lenders, in
lender attitudes toward liquidity, and in other factors affecting the
liquidity balance in the economy.