|Economics and Finance Dictionary
|WHAT IS MONETARY POLICY?
Jan 10, 2008: Monetary policy deals with the money supply and interest rate management. Central Bank of a
country prepares the monetary policy. The Central Bank inserts appropriate amount of money into the
economy or withdraws the required amount of money from the economy to control interest rate which is set
for short term. Short term interest rate is expressed in many names. They are: Inter-bank interest rate, money
market rate, call money rate, overnight interest rate, overnight policy rate, Fed Fund rate, official cash rate
WHO IS RESPONSIBLE FOR MONETARY POLICY?
Jan 10, 2008 Generally Central Bank is responsible for implementing monetary policy.
WHETHER CENTRAL BANK IS INDEPENDENT?
Dec 29, 2007: The situation varies widely from country to country. It is observed that Central Banks in
developing economies are somehow under the control of the Government meaning that Central Banks are
unable to formulate monetary policy independently. They need to get approval from the Government. Central
Banks are found to be independent in developed world especially in OECD (Organisation for Economic
Cooperation and Development) economies. The OECD is a group of 30 most developed nations in the world.
Independency of the Central Bank is one of the criteria of knowledge based economy. If the Central Bank is
not independent, that particular country is not knowledge based.
WHETHER INDEPENDENT CENTRAL BANK IS NECESSARY?
Dec 26, 2008: Historically we have observed that Central Banks with greater independence have been able
to tackle inflation or deflation successfully. In the knowledge based economies, inflation rate has been
maintained within 2 percent level.
WHAT DOES MEAN BY INFLATION?
Dec 20, 2007: When the prices of goods and services on average go up we call it inflation. Inflation could be
two types. They are cost push inflation and demand pull inflation.
Cost push inflation
Cost push inflation: When the prices of inputs (such as energy) go up, the production cost goes up and
hence price level. For example, if the price of crude oil goes up, the production cost also goes up. So there
Demand pull inflation
When there exists excess demand or excess spending in the economy than the availability of goods and
services, demand pull inflation occurs. For example, when an economy grows very fast, people get
employment and income. Hence there creates excess demand causes demand pull inflation.
WHAT ARE THE EFFECTS OF INFLATION?
Dec 15, 2007: An economy has many enemies. Inflation is considered to be the worst enemy of an economy.
It has a number of adverse impacts: They are:
Purchasing power of the people goes down especially for the fixed income earners as the prices of goods
and services have gone up. Value of the money goes down. Goods and services producing in the economy
become less competitive in the world market due to high price and finally living standard goes down
HOW TO TACKLE COST PUSH INFLATION?
Oct 27, 2007: Following policies need to be adopted. They are: There requires to reduce overall spending
ranging from private to government sector.
Central Bank will hike interest rate using its monetary instrument so that lending of the commercial banks
decline and hence money supply. Central Government will come up with a balanced budget or reduce its
deficit to reduce excess spending which causes inflation. Throughout the beginning of 1990s to mid of 2000s
Japanese economy faced deflation. So to tackle the deflation, Central Bank of Japan kept interest rate at
almost zero percent to increases money supply in the economy. Many comment that deflation in Japan is due
to cheap Chinese products that have flooded Japanese market, pulling the general prices down.
HOW MUCH INFLATION IS DESIRABLE?
Oct 15,2007: Generally 1-2 percent inflation is desirable as consumers can afford. Moreover, producers can
make some profit and hence get encouraged. So 1-2 percent inflation is good for the economy. Most of the
developed economies are maintaining their inflation within 1-2 percent formulating an appropriate monetary
Oct 14, 2007: When the prices of goods and services go down, we call this situation as deflation. It is just
opposite of inflation. Generally producers get discouraged for further production as the prices are low and
hence low profit. Inflation or deflation both are the worst enemy for an economy.
TYPES OF MONETARY POLICY
Oct 12, 2007: onetary policy is of two types. They are expansionary monetary policy and tightening monetary
Expansionary monetary policy
Expansionary monetary policy is set by Central Bank which expands money supply and reduces interest rate
in the economy. Generally when the economy is in recession, Central Bank increases money supply in the
economy to tackle recession. When the Central Bank injects money into the economic system, interest rate
(inter-bank interest rate) goes down and hence lending and saving
interest rate. Lower lending interest rate increases investment and hence greater employment and output.
Expansionary monetary policy is also called easy money policy.
Tightening monetary policy
It is the policy set by Central Bank to decrease money supply in the economy. Generally, when the economy
is in inflation, Central Bank uses its various instruments to reduce money supply in the economy to reduce
aggregate demand or spending to tackle inflation. With the reducing of money supply, rate of interest rate
goes up which leads to lower level of spending. Low level of spending helps in tackling inflation especially
demand pull inflation.
WHAT IS FISCAL POLICY?
Oct 13, 2007: Fiscal policy refers to the spending and income of the Central Government. Central
Government earns money through a number of tax channels while spend it for the economy.
TYPES OF FISCAL POLICY
Fiscal policy has two aspects. They are deficit budget and surplus budget
When the spending of the Central Government is more than its income, it is known as deficit budget. For
example, Federal Government of Malaysia is continuously making deficit budget since the Asian Crisis that hit
the region in 1997/1998. The reason behind the deficit financing is to enhance economic activities to boost
The United States of America is making deficit budget for the last few decades expect few years in 1990s
during the reign of President Bill Clinton. Deficit financial is adopted when the economy is in recession.
On the other hand, when the government spending is less than income, it is called surplus budget.
Federal Government of Malaysia adopted surplus budget before the Asian crisis to tackle the overheated
When the government adopts surplus budget, economic activity gets squeezed and hence inflation may
tackle. In other words, surplus budget is adopted when the price level is appeared to hike.
WHETHER MONETARY POLICY IS MORE EFFECTIVE THAN FISCAL POLICY?
Oct 10,2007: As said, fiscal policy is formulated by the Central Government. Since the Central Government
has huge mechanism to implement its fiscal policy, it takes longer time to affect the economy.
On the other hand, monetary policy can be implemented immediately with a change in money supply
controlled by the Central Bank. So, monetary policy has immediate affect while it takes longer time to
implement fiscal policy.
WHY DOES NOT CENTRAL BANK PRINT MONEY AND INSERT IT INTO ECONOMY FOR HIGHER
Oct 9, 2007: Only Central Bank has the Authority to print money. If the Central Bank prints huge amount of
money and use it to meet the debt of the government or government operation, it would simply increase
money supply without increasing any output. As money supply increases without increasing any output, it
would simply bring inflation.
WHAT IS THE TARGET OF THE MONETARY POLICY?
Oct 6, 2007: Target of the monetary policy varies from country to country. Some of the targets are
• Inflation targeting
• Monetary aggregate
• Fixed exchange rate
• Mixed policy
Central Bank set the monetary policy in such a way so that inflation rate stays at a targeted level.
Most of the modern economies of today are following inflation targeting policy.
Under this target, monetary growth (M1, M2 or M3) would occur at a constant rate. This policy is
pursued in 1980s. This aspect of monetary policy is called monetarism.
Fixed Exchange rate
Central Bank sale and buy the foreign currency daily basis to maintain a fixed exchange rate.
Multiple targets are inflation, employment, growth etc. If multiple targets are taken, it is difficult to
achieve all the goals at a time. We can not get all at a time.
WHAT IS INTEREST RATE?
Oct 9, 2007: The interest rate is the cost of payment for a loan or a gain from a deposit.
INTER-BANK INTEREST RATE
Oct 9, 2007: It is an interest rate at which one financial institute (bank) charges other financial
institute on loan.
WHAT IS BOND?
Oct 9, 2007: In brief, bond is a certificate that helps to borrow money from the market.
Government, local municipality or big company needs money to finance their various projects. So they borrow
money from the market by selling bond which is attached with a particular amount of coupon or interest
income. Example, US government issues treasury bonds and notes to finance its deficit.
Experiences suggest that US government bonds are the safest in the world as the US government has never
been defaulted to pay when bonds get matured. The coupon rate or interest rate attached with US
government bonds appear to be lower than other bonds due to its safety.
WHAT IS YIELD TO BOND?
October 9, 2007: Yield is a return you get from buying a bond. Yield to bond can be calculated in
two ways. They are:
1. Current yield
2. Yield to maturity
1. Current yield
The formula to calculate current yield is very simple. Current yield = coupon amount / price of the bond.
Example, a bond price is $ 1000 and the interest amount or coupon amount is $ 100 per annum, the current
yield would be 10 percent. If the price of the bond goes down to $ 800, the current yield would be 12.50
percent. On the other hand, if the price of bond goes up to $ 1200, the current yield becomes 8.33 percent.
So it indicates that price of the bond and yield has an inverse relationship. Generally yield, coupon rate and
interest rate are same in meaning.
2. Yield to maturity (YTM)
The calculation of bond yield using yield to maturity is a complicated one but very meaningful than current
yield method. Whenever, bond investor talk about yield, they refer to yield to maturity
concept. For example, take a bond which has $100 face value and 6 percent coupon rate (interest income) is
attached herewith. This bond would be matured after one year from now. The holder of the bond would
receive $ 106 after one year as soon as the bond gets matured. So as per formula, the price of the bond as
Price of bond (6% interest, 1 year maturity) =
Here the value ‘r’ refers to yield to maturity. If the price of the bond stays at face value at $ 100, the yield to
maturity (r) becomes 6 percent meaning that coupon rate and yield to maturity is same.
If the price of the bond increases to $102, yield to maturity stands at 3.92 percent. On the other hand, if the
bond prices plummet to $ 99, the yield to maturity goes up to 7.07 percent. So it indicates that yield to
maturity and bond price varies inversely. If the price of bond goes up, yield goes down and vice versa.
So when the price of bond is above the face value ($100), we call this situation as capital gain while the price
is below the face value, it is capital loss. So yield to maturity shows total return we will receive if we can hold
the bond until its maturity. In other words, yield to maturity equals to all the interest receive from the
purchasing time to maturity (assume we will reinvest all the interest payment) plus any gain (if we can
purchase the bond below its face value) or loss (if the bond is purchased above its face value).
YIELD CURVE AND PREDICTOR OF ECONOMY
Oct 9, 2007: The yield curve generally plots the yield to maturity of treasury securities with different maturities
ranging from the shortest maturity to longest one. In the yield curve, vertical axis represents yield to maturity
while horizontal axis represents duration of maturity.. In case of US treasury securities, shortest maturity is
three months while longest maturity is 30 years.
Typically a yield curve is gently upward sloping meaning that short term bond yield is lower than long term
bond yield. The yield curve is called normal curve. It also means that long term bond investor is expecting
higher yield than short term investor as the money would be parked for a longer time period in case of long
term bond. Normal curve also indicates that economy is expecting growth in the future.
But when the normal curve or yield curve becomes steeper, it indicates that long term investors are expecting
a reasonably higher yield compared to short term bond holder. It means that your return from long term bond
would be higher than short term bond return. A steep yield curve indicates that the economy is going to
experience robust growth.
Sometimes yield curve becomes inverted which means that short term bond yield is higher than long term
bond yield. An inverted yield curve indicates the economy is about to experience a sluggish growth and
recession in future.
Generally when the economy grows very fast, the inflation is likely to appear due to excess demand in the
economy. When the inflation comes in, prices of bonds lose its real value. So investment in bond is no longer
a good choice unless and until its yield covers inflationary value.
This dictionary is produced and maintained by Sayed Hossain