Understanding Interest Rates and Monetary Policy Flashcards

Flashcards for reviewing key vocabulary and concepts from an Economics lecture on interest rates and monetary policy.

Yield to Maturity

The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.

Simple Loan

A debt instrument where the borrower receives principal amount and repays the lender with the same amount plus interest at the end of the loan duration.

Fixed Payment Loan

A debt instrument where the borrower receives principal amount and pays it back with fixed payments composing principal and interest over the loan duration.

Coupon Bond

A debt instrument where the bondholder receives periodic coupon payments during the life of the bond, and the face value (principal) at maturity.

Discount Bond

A debt instrument that is bought at a price below its face value, with the face value repaid at the maturity date; it does not make any coupon payments.

Consol (Perpetuity)

A bond with no maturity date that does not repay principal but pays fixed coupon payments forever.

Rate of Return

The total earnings of the owner during the holding period of the bond, as a fraction of the purchase price.

RET

The return from holding the bond from time t to time t+1.

Current Yield

The yearly coupon payment divided by the price of the consol.

Nominal Interest Rate

Nominal interest rate without an allowance for inflation.

Real Interest Rate

Interest rate adjusted for changes in the price level (inflation) to reflect the real cost of borrowing.

Wealth (W)

The total resources owned by the individual, including all assets

Expected Return (RETe)

Return expected over the next period on one asset relative to alternative assets

Risk (σ)

Degree of uncertainty associated with the return on one asset relative to alternative assets

Liquidity (Liq)

The ease and speed with which an asset can be turned into cash relative to alternative assets

Default Risk

The interest rate on bonds with default risk

Risk Premium

The spread between the interest rates on bonds with default risk and the interest rates on Treasury bonds

Yield Curve

A plot of the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations.

Expectations Theory

Theory that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.

Segmented Markets Theory

Theory in which bonds of different maturities are not substitutes at all, and the interest rate for each bond with a different maturity is determined by the demand for and supply of that bond.

Liquidity Premium Theory

Theory stating that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond.

Liquidity Preference Framework

The Keynesian model that determines the equilibrium interest rate in terms of the supply and demand for money.

Loanable Funds

Market that determines the equilibrium interest rate is in terms of the supply and demand for loanable funds.

Asset Market Approach

Equilibrium interest rate will change as the demand and supply shifts in the bond market.

Balance sheet

Total assets=Total Liabilities+ Net worth

Asset transformation

selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

reserve requirement ratio (r)

Fraction of deposits banks are required to keep at the Central Bank

Reserves (R)

Sum of deposits at CB and vault cash which can be used for the reserve requirements.

Asset Management

An indicator for how to conduct business such that high returns on loans and securities should be maximized, risk should be minimized, and adequate liquidity should be available.

Liability Management

Funds can be raised by selling new equity or from retained earnings. Banks are expected to have Liabilities higher than what assets are worth, which is called insolvency.

Capital Adequacy Management

Capital is required to be adequate as a buffer to handle bad stocks, which helps to prevent bank failure. The amount of capital a bank has affects the return for the owners (or equity holders) of the bank.

Credit Risk

A state when it is likely for a bank to be unable to pay its depositors or other creditors, potentially leading to bankruptcy.

Interest-Rate Risk

The potential for losses to arise from changes in interest rates.

Instrument Independence

Central Bank's influence in monetary policy such that they are able to set their own goals and are able to use the means to reach these goals.

Open Market Operations (OMO)

Open market operations are the CB’s purchase or sale of government securities in the open market

Discount Rate

It is the rate charged to discount credit extended by the CB to the financial intermediaries

Policy Rate

a short-term interest rate that the monetary policy committee uses to determine future policies at monthly meetings.

Credit Facility

to provide more loans to banks or other non-bank entities facing financial difficulties

Monetary Base (MB)

High-powered money; central bank money

Irrational Exuberance

The idea that financial conditions and market prices are difficult to predict or rationalize using available information.

Macroprudential Policy

Using appropriate strategies and regulatory instruments to take precautions for enhancing the stability of the financial system as well as monitor the financial markets.

Currency Ratio

The ratio of currency to checkable deposits.

Money Multiplier

Describes the amount of the money stock that can be afforded for every dollar that is inside the monetary base.

Nominal Anchor

a nominal variable such as the inflation rates, money supply, or any monetary aggregate where monetary policymakers use to tie town the price levels

Time Inconsistency Problem

Where decision makers preferences change throughout time

Fiscal Policy

A government’s control over revenues and expenses. It is a tool used to steer a country's economy.

Monetary Policy

A monetary authority or council exists to manage the production and circulation of a state or nation's currency and credit.

Mean Reversion Idea

Suggests that there is a mean value (equilibrium value ) for the interest rate and if the short term value is below that it is expected to increase towards the mean value

Rate of Return on a Coupon Bond

measures the total earnings of the owner during the holding period of the bond when the maturity is longer than the holding period

Market Equilibrium

when interest rate is determined via the interaction of supply of and demand for bonds

Lender of Last Resort

To make sure solvent institutions can meet their depositors’ withdrawal demands, in economic crises where there is an increased liquidity preference