Yield-curve movements and fiscal retrenchments

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