Final answer:
A steeply upward sloping yield curve indicates that investors expect interest rates to rise significantly in the future. This expectation is often linked with impending economic expansion and increasing inflation, which drive up demand for credit and the cost of borrowing.
Step-by-step explanation:
Yield curves are graphical representations of the relationship between interest rates and bonds of equal quality but different maturity dates. A steeply upward sloping yield curve typically suggests that investors anticipate higher interest rates in the future. This expectation of increase is due to a variety of economic factors, such as inflation and the central bank's monetary policy.
A yield curve might become steeply upward sloping when there is an anticipation of economic expansion, which often leads to increased inflation and subsequently to a rise in interest rates. This cause-effect relationship reflects the fact that as demand for credit increases during expansions, the cost of borrowing (interest rates) goes up, creating a steeper curve. Thus, the correct answer is: 1) When interest rates are expected to rise significantly in the future.
Connection to the Business Cycle
The fluctuation of interest rates referenced in the scenarios highlights the connection between economic activity and the yield curve. For example, the high interest rates of the early 1980s were linked to high inflation, while decreases in rates often correspond with recessionary periods. A steep yield curve often occurs during the early stages of an economic expansion.