Liquidity plays an important role in explaining how banks determine their allocation of funds. This paper analyses whether this fact can explain the term structure of interest rates and yield spreads. The paper models banks' demand for liquidity in a manner similar to that used to study household need for liquidity, namely, by using a cash-in-advance type model. The paper finds that the shadow price of the cash-in-advance constraint plays an important role in determining yield spreads. The model predicts that short-term rates respond more to monetary policy than long-term rates, consistent with earlier empirical findings. The empirical part of the paper shows that the expectations hypothesis might be salvaged under the maintained hypothesis concerning the liquidity premium and default risk premium. This paper confirms the finding that monetary contractions raise nominal interest rates.
Term structure of interest rates Expectations hypothesis Yield Spreads Liquidity Cash-in-advance constraint Monetary policy