YIELD-CURVE MOVEMENTS AND FISCAL RETRENCHMENTS

We analyze the term structure of interest rates when markets anticipat e a fiscal-policy change in the near future. Lf the anticipated change consists of spending cuts, a fiscal retrenchment, interest rates of a ll maturities increase, but short rates increase more than longer rate s (the yield curve therefore becomes inverted), If however there is un certainty on the type of the fiscal-policy change, the prediction of t he model can be radically different: provided agents attach a positive probability to an increase in public spending, the yield curve may be come steeper in anticipation of a reform. (C) 1997 Elsevier Science B. V.