Final answer:
A flat yield curve under the liquidity premium theory suggests future short-term rates are expected to remain constant. Interest rates decline due to a rise in the supply of funds as it leads to a lower equilibrium price for borrowing in the financial markets.
Step-by-step explanation:
Liquidity Premium Theory and Interest Rate Changes in Financial Markets
According to the liquidity premium theory, a flat yield curve indicates that investors expect future short-term rates to remain constant. A flat yield curve occurs when the interest rates on bonds with different maturities are the same. This suggests that investors are not predicting any significant changes in the economic conditions that would influence interest rates significantly up or down.
When addressing changes that would lead to a decline in interest rates in the financial market, an increase in the supply of funds causes interest rates to fall. This is because the added supply of funds meets the same or lower demand, which under basic economic principles, leads to a lower equilibrium price, which in the context of financial markets equates to lower interest rates. Conversely, a rise in demand, a fall in supply, or a fall in demand would typically increase, decrease, or have an indeterminate effect on interest rates, respectively.