Monetary Policy &Bond Market

Money and Money Markets

• Money plays an important role in the economy. It is used
to settle the transactions which make up the circular flow
of income. Also, the price of holding money is the
interest rate, which has a role to play in determining
consumption and investment.

• Therefore, monetary policy – the act of controlling the

supply or price of money – may exert a powerful influence
over the economy.

• Like all prices, the interest rate is determined by demand

and supply in the money market.
 Money market
• Money market basically refers to a section of the
financial market where financial instruments with
high liquidity and short-term maturities are traded.
• Money market has become a component of the
financial market for buying and selling of securities
of short-term maturities, of one year or less, such
as treasury bills, commercial papers and certificates
of deposit.

• https://economictimes.indiatimes.com/definition/money-
market 
Definition….
•Money market consists of negotiable instruments such as
treasury bills, commercial papers. and certificates of deposit. It
is used by many participants, including companies, to raise
funds by selling commercial papers in the market. Money
market is considered a safe place to invest due to the high
liquidity of securities. 

•It has certain risks which investors should be aware of, one of
them being default on securities such as commercial papers.
Money market consists of various financial institutions and
dealers, who seek to borrow or loan securities. It is the best
source to invest in liquid assets. 
 The Bond Market
• The opportunity cost of holding money is the rate of
interest that could have otherwise been achieved by
investing in bonds. It is for this reason that the interest
rate is referred to as the price of money.

• We start with a simple type of bond known as a Treasury

Bill (often referred to as a T-bill). The Treasury bill is a
means by which the government can borrow to fund its
deficits or to exert some influence in the money markets.
They are essentially short term (namely, 91 day, 182 day
and 364 day.) which promise to pay a fixed amount on
maturity..
 The Bond Market
• For example, the UK government could sell a bill offering
to pay £100 in 91 days’ time

• The price at which this bill sells for is likely to be less than
£100, and this is what makes the bill attractive to investors.
Suppose the bill is sold for £98. This will offer the investor
a return of £2 in 90 days. The rate of return will simply be
given by: 100  98
r  2.04%
98
• This is equivalent to an annual interest rate of
approximately 8%, because 91 days represents about a
quarter of a year. This rate of return can simply be
understood as the interest on the bill.
 The Bond Market
• In general terms, the rate of interest on a bond that
is purchased at price and pays on maturity is:
r
P P  B

PB
• As T-bills are directly marketable assets, their price
and thus the rate of interest will change with
fluctuations in demand and supply in the bond
market. As bonds are a direct substitute for money,
the interaction between the bond and money
markets will be influential in determining the
interest rate.
Interest rates and bond prices
have an inverse relationship
The Term Structure of Interest
Rates: Yield Curves
• The maturity of a bond is the length of time over which
the bond makes payments.
• The yield on a bond describes the per period return until its
maturity and can be thought of as the average return each
period. The yields on bonds with maturities of a year or
less are known as short run interest rates, whilst the yields
on bonds of longer maturities are described as long run
interest rates.
• There is no reason why the short run and long run interest
rates need to be the same. This is because the demand and
supply of money and therefore the equilibrium interest rate
can change over time.
 Yield Curves
• The term structure of interest rates describes the yields on
bonds of different maturities.
• The yield curve is a graphical representation of this
concept, which plots yields against maturity.
• If the yield curve is upward sloping, then it suggests that
future interest rates are expected to be above current rates.
• If the yield curve is downward sloping, then it suggests that
short term rates exceed long term rates.
Yield Curves
 Yield Curves
• It is a useful description of the expectations that financial
markets have concerning the future state of the economy.
• Normally, an upward sloping yield curve implies that
growth and/or inflation will increase in the future, so long
term interest rates exceed those in the short term.
• Alternatively, a downward sloping yield curve is an
indicator that growth and/or inflation will be lower in the
future, implying a downward trend in interest rates over
time.
Open Market Operations
• By buying and selling bonds to the general public, the
government can attempt to control the size of the monetary
base, and therefore the money supply.
– High powered money or monetary base refers to that currency that has
been issued by the Government and Reserve Bank of India. It refers to the
total amount of bank notes and coins circulating in the economy.
• When the government sells bonds, the private sector
purchases them with cash, drawn from the reserves of the
banking sector. The money supply would then be expected
to fall by an amount equal to the product of these reserves
and the money multiplier.

• If the government wished to increase the money supply,

then it would simply purchase bonds from the private
sector. Cash would then be deposited in the banks and lead
to a multiplied increase in the money supply.
 RBI to sell govt bonds worth Rs 10,000 crore via open market
Sep 29, 2017
The Reserve Bank of India (RBI) today said it would sell government bonds worth
Rs 10,000 crore through Open Market Operations (OMO) to mop up liquidity from
the system.

"Based on the current assessment of prevailing and evolving liquidity conditions, the
RBI has decided to conduct sale of government securities under Open Market
Operations for an aggregate amount of Rs 100 billion on October 12, 2017 through
multi-security auction using the multiple price method," the central bank said in a
statement.

As part of the OMO, the RBI will sell government securities maturing in 2019
(bearing interest rate of 6.90 per cent), 2021 (7.80 per cent), 2022 (8.08 per cent),
2024 (7.35 per cent) and 2030 (7.88 per cent).
 

Read more at:https://economictimes.indiatimes.com/markets/bonds/rbi-to-sell-govt-bonds-worth-rs-

10000-crore-via-open-market-operations/articleshow/60886632.cms
 RBI to infuse Rs 25,000 crore through OMO in May

https://economictimes.indiatimes.com/markets/bonds/rbi-to-infuse-rs-25000-crore-through-omo-in-may/articleshow/69012786.cms?from=mdr
Open market Operations
Pushing the Interest Rate Down
Open market Operations
Pushing the Interest Rate Up