Question

Explain the relationship between monetary policy and the internal rate of return to bonds (what it is and how it works). Outline how monetary tightening impacts the internal rate of return to bonds.

Answer 1

Globally there are several policies for the smooth administration and functions of the government.Policies can be monetary policy,fiscal policy ,financial policies etc .Monetary policy is the policy which is related to central bank of the country.Monetary policy helps central bank to set various rates.It has its own quantitative and Qualitative techniques.Monetary policy as its core is about determining interest rates.These interest rates can be better understood as risk free rate of returns which is imposed on bonds.This risk free rate of returns has a large impact on demand for all financial securities like bonds.Therefore bonds are significantly affected by monetary policy.The returns of rate from bond is based on the bond's coupon payments divided by its market price,as price of the bond increase its yields will fall.Meanwhile interest rates make bond price rise and its yields to fall.In other way round if rising interest rate cause bond price to fall and bond yield to rise.These powers are utilized by the government to moderate savings in the economy and it looks good to hold off deflationary forces by lowering interest rates,leading to increase in asset prices which in turn midly stimulating effect on the economy.When bond yields fall it results in lower borrowing costs for government ,leading to increased spending.During this event mortgage rates also decline with the demand for housing which is caused due to impact of monetary policy on internal rate of returns.