NoteTermStructure

NoteTermStructure - Lecture Note on Money and the Term...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
1 Lecture Note on Money and the Term Structure Econ 135 - Prof. Bohn Yields on Treasury and corporate bonds usually rise when the Federal Reserve increases the Fed funds rate; bond prices fall. The point of this note is to explain why the yield movements are not uniform. Usually, yields on longer-term bonds move less than the yields on shorter-term bonds. Sometimes, the very long end of the yield curve even moves in the “wrong” direction, responding to a Fed funds rate increase with rising prices and a fall in yields, especially if the Fed moves aggressively, with comments promising a vigorous fight against inflation. Can we explain these observations? This note combines term structure theory (Mishkin ch.6) and our knowledge of money and interest rate linkages to understand the effects of monetary policy on the term structure. Introduction : In the Lecture Note on Real Effects of Monetary Policy , we traced out how various changes in monetary policy affects nominal and real interest rates over time. Briefly, a temporary monetary expansion [contraction] will reduce [increase] the nominal and the real interest rate, followed by a return to the original level. A permanent monetary expansion [contraction] will also reduce [increase] the nominal and the real interest rate in the short run. But over time, the nominal interest rate will rise [fall] by an even larger amount. In the long run, the nominal interest rate will show an overall increase [decrease] by an amount equal to the change in the inflation rate--reflecting the Fisher effect. In a term structure context, we must distinguish different interest rates on bonds of different maturities. The results in the previous Lecture Note are best interpreted as describing the dynamic effects of monetary policy on relatively short-term interest rates . This note is about how monetary policy affects interest rates on bonds with different maturities, especially long-term bonds. Let’s collect what we know about this issue: 1. We know term structure theory (Mishkin’s ch.6): The liquidity premium/preferred habitat theory tells us that interest rates on relatively long-term bonds are the average of current and expected future short term interest rates plus a term premium. 2. We know how monetary policy affects short-term interest rates now and in the future; see the previous Lecture Notes. 3. We know that markets are efficient (Mishkin’s ch.6): If investors are smart enough to know macroeconomic theory, they will immediately recognize that as monetary changes, it will have the impact on future short term interest rates as outlined in the previous Notes.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 Taken together, this means that when monetary policy changes, investors will presumably exploit
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 12/26/2011 for the course ECON 135 taught by Professor Bohn,h during the Fall '08 term at UCSB.

Page1 / 4

NoteTermStructure - Lecture Note on Money and the Term...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online