Final answer:
the correct option is 1. Investors' expectations of decreasing inflation would typically lead to a downward-sloping yield curve according to the expectations hypothesis, reflecting anticipated lower future rates due to sluggish economic conditions or possible recessionary trends.
Step-by-step explanation:
According to the expectations hypothesis, when investors expect inflation to decrease, it is typically associated with an anticipation of a slowing economy, or even a recession. Lower expected inflation implies that investors would expect lower nominal interest rates in the future as the central bank might engage in expansionary monetary policy to stimulate economic activity. Consequently, this scenario could lead to a downward shift of longer maturity yields relative to shorter maturity yields, showing an expectation of reduced interest rates as time progresses. Therefore, investors' expectations of decreasing inflation will result in a downward-sloping yield curve. This is because long-term interest rates are expected to be lower than the short-term rates as a result of the expected decrease in inflation over the long term.
The yield curve is a graphical representation of interest rates on debts for a range of maturities. It illustrates the market's expectations of future interest rates and can significantly affect economic decision-making. The shape of the yield curve is a powerful indicator of future economic conditions as viewed by bond investors. A downward-sloping yield curve can suggest that lower rates and slower economic growth are anticipated in the future.
In summary, if investors expect inflation to decrease, this would typically lead to a downward-sloping yield curve, as per option 1). This is the correct answer to the student's question regarding the result of decreasing inflation expectations on the shape of the yield curve.