Yield Curve Inversion and the Incidence of Recession: A Dynamic IS-LM Model with Term Structure of Interest Rates X. Henry Wang & Bill Z. Yang Published online: 16 February 2012 # International Atlantic Economic Society 2012 Abstract This paper attempts to explain why yield curve inversion may serve as a leading indicator of recessions. It employs an IS-LM model with the term structure of interest rates and provides a formal phase-diagram analysis of dynamic adjustment process. It demonstrates that the occurrence of yield curve inversion is an off- equilibrium phenomenon after an adverse shock in the adjustment process of interest rates and output, and that an inverted yield curve may lead, but does not lead to, a recession. Keywords Yield curve inversion . Recession . The IS-LM model . Term structure of interest rates . Phase diagram JEL E00 . E30 . E40 Introduction It has been well documented in the literature that the yield curve serves as a leading indicator of output with most being empirical studies (e.g., Estrella and Hardouvelis (1991), Estrella and Mishkin (1997), Berk (1998), among others). Theoretical re- search to explain such a very interesting observation seems to have lagged behind until Estrella (2005), to our knowledge. It is a subject of macroeconomics that examines the connection between interest rates and real economic activities. Hence, Int Adv Econ Res (2012) 18:177–185 DOI 10.1007/s11294-012-9350-7 The authors would like to thank Richard Cebula, Chris Coombs and the audiences in the 72nd International Atlantic Economic Society (IAES) Conference at Washington DC for their comments on earlier versions. Bill Yang is grateful to the Department of Finance and Economics, Georgia Southern University for the research support (Summer 2011). The standard disclaimer applies. X. H. Wang Department of Economics, University of Missouri-Columbia, Columbia, MO, USA B. Z. Yang (*) Department of Finance and Economics, Georgia Southern University, Statesboro, GA, USA e-mail: billyang@georgiasouthern.edu