9 The Monetarist Rule

Upon completion of this chapter you should
be able to explain the crucial role played by the inverse relationship between the interest rate and the price of bonds; and
understand how monetary policy affects the economy through interest rates.

10.1
A Multitude of Interest Rates
Macroeconomists talk of "the" interest rate, but in fact a myriad of interest rates exist, depending on such variables as time to maturity of the financial asset, how the interest is taxed, how liquid the financial asset is, and what is known about the borrower (in particular, the risk of default). Short-term debt instruments, of maturity less than a year, are traded in what is called the money market. Longer-term instruments are traded in the capital market.
Typical interest rates in the money market are T-bill rates (on U.S. government Treasury bills); commercial paper rates (on loans by financial institutions to large banks and corporations); the federal funds rate (on very short-term loans between banks of their deposits at the Fed); and the Eurodollar rate (on U.S. dollars deposited outside the United States). Typical interest rates in the capital market are the mortgage rate, the corporate bond rate, the Treasury bond rate, and the municipal bond rate.
All these interest rates tend to move together, however, so little harm is done by analyzing the economy in terms of a single representative interest rate, as we do throughout the rest of this book. For those interested, the "Currency Trading" column in the "Money & Investing" section of the Wall Street Journal lists several key U.S. and foreign interest rates in about 20 categories.
10.2
Interest Rates and the Price of Bonds
The inverse relationship between the interest rate and the price of bonds is fundamental to understanding how monetary policy affects interest rates and why people in the financial world are always so worried about the future course of the interest rate. This inverse relationship is illustrated for the two main types of bonds coupon bonds and discount bonds.
A coupon bond pays the owner of the bond a fixed interest payment each year until the bond matures when the face value (or par value) of the bond is paid. The name "coupon bond" comes from the fact that, until recently, the bond owner had to clip a coupon from the bottom of the bond each year to receive this fixed interest payment. Now these payments are made electronically.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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