The Inverted Yield Curve in a 3-Equation Model

The power of an inverted yield curve to predict recessions is widely discussed in the financial press, yet most undergraduate textbooks provide little discussion of this stylized fact. This paper fills this gap by extending a 3-equation textbook model to include an accessible treatment of a term structure of interest rates formed by the one-period policy rate and a two-period rate that obeys the Fisher Equation. The Phillips curve features partially anchored adaptive expectations, while financial markets and the central bank have perfect foresight. Using this framework, we show that raising the policy rate in response to an inflation shock inverts the yield curve. Whether this inversion foreshadows a recession, however, depends on the bank’s monetary policy rule, which we illustrate using numerical examples. In particular, we show that, with anchoring and an output-gap averse central bank, inflation can stabilize and the yield curve can invert without an ensuing recession.