Monetary Policy and Investment Opportunities

By Laura S. Nowak | Go to book overview

4
The Structure of Interest Rates

The Federal Reserve's monetary policy affects short-term interest rates and long-term interest rates with a greater impact on the short-term rates. The relationship between short-term and long-term rates, depicted by a yield curve, is sometimes steep, flat, or inverted. Monetary policy impacts on the shape of the yield curve as well as on the relationship between Treasury rates and other rates.

We sometimes hear that interest rates went up or went down. This statement refers to the fact that different interest rates tend to move in the same direction at approximately the same time. (See Figure 4.1.) But the term interest rate is very general. Several terms are used to describe the return on money, and each has a slightly different meaning. Some of the terms used to describe the return on money are the coupon rate, the effective rate, the current yield, and the yield to maturity.

The coupon rate is the rate that the borrower will pay to the lender in each period of time. It is usually associated with bonds, and it is printed in he agreement. If the coupon, say 8 percent, is paid semiannually, the first payment can be reinvested after six months at the prevailing rate. Then, the annualized rate of return will be higher than the coupon rate. For example, if the coupon rate is 8 percent, and if the first payment can be reinvested at 8 percent, then the annualized rate of return will be 8.16 percent. If the coupon is paid monthly instead of semiannually, and each payment is reinvested, the annualized rate of return would be 8.3 percent. The annualized rate of return is also called the effective rate.

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