Money markets versus Bond Markets: Comparison of the two markets and

identification of possible similarities, differences and special characteristics.

Description of how they affect and how they are affected by monetary policies.

©2016 All rights reserved Constantinos Challoumis

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Contents
1. Introduction ........................................................................................................................... 2
2. Money markets versus Bond Markets, differences and similarities ..................................... 2
3. Monetary policy in Money Markets and in Bond Markets.................................................. 11
4. Epilogue ............................................................................................................................... 18

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1. Introduction

The yield curve shows the interest rates, at a set point in time, of bonds having equal credit
quality, but differing maturity dates. The curve is used to predict changes in economic output and
growth. This yield curve is used as a benchmark to compare money markets with bond markets.
The bond markets provide a long-term source of funds. Even the case of shortest-dated bonds
have an initial maturity of more than one year. On the other hand in money market funds are
borrowed and lent for a maximum of one year. Through the yield curve we analyze the
differences between the money markets and bond markets as follows.

2. Money markets versus Bond Markets , differences and similarities

As referred before the first difference between money markets and bonds is that bonds have
duration that is totally different than bills and the other money market instruments. So, bonds
provide a long-term source of funds. The shortest-dated bonds have duration more than one
year. Bonds offer default rate of interest that determined to fix value and have the claim on the
issuer in the case of issuer’s bankruptcy. In most cases, governments issued bonds, and many
times also large corporations issued bonds, which are trustful investments. The basic problem
that bondholders have to deface is the inflation. The combination of inflation and sticky
nominal value of bonds imply that there exists a diminish of their real value. With an increase
in inflation, then prices change immediately and inversely in the case of expectations of inflation.
The householders are at risk if they don’t continue with redemption. On the other hand money
markets, funds are borrowed for less than one year, or maximum limit could be the one year. The
distinguishing between money markets and the categorization of them established in two cases,
with the first to be the way which they are traded, and the other one is based on the identity of
the borrower. The key point to money markets is the repurchase agreements, which involve a sale
of securities with an agreement to buy them back in the near future for a price that determines
the cost of the funds achieved. At that point must mention that short-term finance with money
markets influence short-term interest rates. There are three basic steps to illustrate the operation
of money market, so to the first one banks offer a guarantee to their clients and then their
deposits can be converted demand into cash. The issue is that reserved pay no interest, banks
hold the minimum quantity of them, and then short-term of reserves must be refunded, so the
solution comes up from the central bank. (Howells and Bain 2005) On the contrary bonds are
fixed interest long term securities. The duration of a long term asset exceeds the one year
period. But, many bonds issued with initial period more than ten years.

According to expectations theory the market expectations of future interest rate dates described
by Irving Fisher and Hicks. A point of departure for the expectations theory is the role of
secondary markets in transforming the effective terms of securities (showing the impact
of secondary markets in bonds, and how this related with yield curve). Supposing that the

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lender for instnace owns a five-year Treasury bond which he purchased in the primary market.
The bond is maturing, but the lender now wishes he had lent for 10 years. If he takes the
maturity payment on his five-year bond and uses it to purchase a second five-year bond, he will,
in effect, have lent for 10 years. The only difference between this and the single 10-year loan is
that the rate of return the lender receives over the coming five years will be determined by
current market conditions, rather than conditions five years ago. On the contrary supposing that
the lender owns a 10-year Treasury bond which he purchased five years ago. He has now decided
that he needs his money and would have preferred to lent for five years. If there were no
secondary market, he would be stuck, he would not be repaid by the Treasury until the bond
matured five years in the future. The key point is that the secondary market allows him to receive
early repayment indirectly, by selling his bond to another lender. If he chooses to sell the bond,
he will, in effect, have lent for five rather than 10 years. The only difference between this and a
true five year loan is that the amount of the repayment will depend on the current market
conditions, rather than conditions five years ago. If there is no uncertainty about future interest
rates, so that lenders today know exactly what market yields on securities with different terms will
be five years in the future. Supposing that the future five year Treasury yield will be identical to
the current five-year yield – say 8 percent. Then the current yield will affect the 10 year Treasury
securities. If there is no uncertainty about future interest rates, current long-term rates must be an
appropriate wighted average of current and future short-term rates. The expectations theory
predicts that, if lenders know for certain that short-term interest rates will remain constant, they
should be indifferent between lending by purchasing short-term securities and lending by
purchasing long-term ones. Long term and short term interest rates should be equal, and
the yield curve should be flat. This prediciton implies that any interpretation for the upward
slope of the curve must be based on the effects of uncertainty about future interest rates. This is
one reason why uncertainty about interest rates affect the value of their securities in the
secondary market, showing with that way the functioning difference of bonds and money
instruments. Supposing the previous paradigm that a lender buys a 10 year security that returns a
yield of 8 percent and sells it in the secondary market after five years. If interest rates have
remained unchanged in the interim, the secondary market price of his security will give him a
five-year yield of 8 percent. If they have risen the price will be lower, and then he will receive a
lower yield. The reason for this price and yield changes is that a security sold in the secondary
market must complete with primary market securities with the same term as its remaining term. If
the market interest rate in primary market securities has risen, the yield on secondary securities
must rise to the same level, since the remaining payments on these securities are fixed, this rise
can be arranged only through a decline in the securities market price. It seems reasonable to
assume that market participants recognize that interest rates may change, but expect them to
remain constant on average. Under this assumption, the expected capital gains on future

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 secondary market sales of securities are
approximately zero. It seems conceivable that
this situation might not bother lenders. There
is the assumption that that the satisfaction of
a person derives from an extra dollar’s worth
of expenditures declines as the total value of
his expenditures increases. If this is so, he will
fin the gain in satisfaction provided by the
extra goods he can purchase if his returns exceed his expectations to be smaller than the loss in
satisfaction from the goods he will have to refrain from purchasing if his returns fall short of his
expectations. This should cause zero expected loss uncertainty about the future returns on his
securities to upset him. A person who behaves like this is said to be risk averse. Since buying
term securities exposes lenders to actuarially fair return uncertainty, while buying securities with
zero terms does not, risk averse lenders will no wish to buy term securities. They will insist on
higher expected yields on term securities than on demand deposits to compromise themselves for
the uncertainty. The notion that financial decision makers are risk averse is widely accepted by
economists. According to the term of premium if the risk of capital loss on securities tends to
increase in proportion to their remaining terms, lenders who demand interest compensation for
bearing this risk will demand more
compensation on long-term securities than on
short-term securities. This will tend to make the
yields on longer term securities higher than
those on securities with shorter terms, it will
tend to make the yield curve upward-sloping.
Abnormal yield curves shows the role of term
premium in determing the shape of abnormal yield curves, the sort that appear when lenders
expect interest rates to change in the future. The actual yield should be given by the sum of the
term-adjusted rate and the appropriate term premium. This can produce curves that slope in one
direction along one part of their range, but in the opposite direction along one part of their range,
but in the opposite direction along another part. If lenders expect interest rates to remain
constant for a short period, and then fall sharply , then the yield curve will apear humped, sloping
upward at very short terms peaking near the term corresponding to the date at which rates are
expected to decline, and sloping downward for a range of terms thereafter. These curves
observed shortly before economic recessions start, because interest rates tend to fall sharply
during recessions. The interest risk and the Term Structure tend to have higher yields than
demand deposits when both are default-free meaning that term securities carry interest risk, but
demand deposits do not. Bonds categorized to the yield curve by time of maturity, with the

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main issue to be the length of maturity always estimated from now. This classification determined
by residual maturity. The classification commonly used is for less than 5 years to be accepted as
short, between 5 and 15 years to be known as a medium, and for the case that is higher than 15
years to be long. Bonds are issued with a par value, and this is redeemed at maturity. Also, it is
plausible that the par value could be issued at a
discount. Additionally could be issued with a
premium to their par value. Coupon is the amount
of money that conventional bonds pay with a
default amount to their holders periodic throughout
their time of existence. The convert of coupon to
coupon rate comes out by dividing the par value.
For instance, if paid a coupon of 10 Euro per year
of a French bond and 10 Pounds per year of a UK
bond then both of them have coupon rates 10 per cent, and will be determined as 10 per cent
bonds. The characteristics of bonds are included in the title or the name of a bond. The
ownership of domestic bonds is registered means that the issuer of the bonds keeps the register
and that implies that must pay the owners of the coupon, because of registered bonds. There are
Eurobonds, and we have some domestic bonds that have the same attitude with the first one that
are characterized as bearer bonds. The difference with the conventional bonds is that are
maintained register, and only the possession of the bond is enough to prove the ownership. The
owner of the bearer bond sends a message to the owner informing him about the claim of
interest payments by detaching the appropriate coupon supplied attached to the bond and
sending it to the issuer at the appropriate time. The use of term of coupon for interest payment
dates comes from the time when all bond were bearer bonds. Another form is the zero coupon
bonds which pay no interest but must then be issued at a discount to their redemption value in
order to provide a return to investors. So, zero coupon bonds seem to be similar with bills with
the difference that zero bonds are long-dated than bills that are short-dated. Also, markets have
developed strips, with each strip to be a single component of cashflow of a bond. The strip is
traded separately and usually consists a government bond. For instance, if there exist a 10 per
cent bond then could be traded as ten separate strips, and this implies nine coupon payments,
each with a different maturity, plus the maturity value of the bond payable at the end of its life.
The mechanism here is based on zero coupon bonds maturing on the appropriate date. There are
two advantages in the case of coupons, with the first one to be related to the tax case, where
there is a capital gain and not an income payment. And, moreover, there is doesn’t exist a risk
with an unexpected fall in interest rates. These bonds have described are known also as straight
bonds, or plain vanilla bonds, or bullet bonds. The general terminology that used to describe the
whole variety, of bonds come from firms, is known as corporate bonds. (Mishkin, Matthews and

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Giuliodori 2015) One kind of corporate bonds is the debentures, which are a subset of bond
which are secured on the assets of a firm. According to debentures there exists a division
between them into floating charge debentures and in fixed charge debentures. In the fixed-charge
debenture holders have the characteristic that rank above the case of the floating-charge
debenture holders, but according to that
case there we have the minus that in the
case of fixed charge debentures the
holders don’t have the enforcement to
ask about the condition of firms as
insolvent. In addition, one more issue is
the case of unsecured loan stocks, with
this bond to have no charge over the
company’s assets. If the unsecured loan
stocks guaranteed by a third party and not
by them, then we have the guaranteed loan stocks. There exists the case that some corporate
bonds are convertibles. This means that these bonds it is plausible to convert to other type of
bonds. So, convertible bonds carry the option to convert at some point in the future to its equity,
or other type of bonds issued by the firm. Moreover, is the case of callable or, puttable bonds,
where the redemption date could take place later at the discretion of the issuer, according to the
callable, or to the holder according to the puttable. The double-dated corporate bonds referred to
the theme that redemption can take place at any time between two dates, and that noted in the
title of double-dated corporate bonds. The index-linked bonds are corporate or government
bonds, and their par value is updated periodically following the price index, and the coupon
payment is also increased by the amount of the recent change in the index. The same mechanism
adjusted and in the case that coupon payment is also increased, according to the increase of the
short-term interest rate. Making a division of these bonds, there are variable rate bonds when
issued by government, and floating rate notes when issued by corporate counterparts. The
preference shares can be distinguished between bonds and equities. The Eurobonds are bonds
issued in a currency which is not the currency of the country that issued the bond. Here, bonds
denominated in domestic currency, but issued in that country by non-residents. For instance, in
London, foreign firms it is plausible to issue bonds, denominated in sterling. On the other hand
discount market contains treasury bills, local authority/utility bills, and commercial bills. The
same happens in the case of commercial paper market, which funds are priced on a discount
basis, like the case of the discount market. The discount factor replaces the paying interest in
convenient issues, because the initial maturities withdraw between one month and twelve month
period. The commercial paper known with the acronym CP expresses the promise to pay the
holder of the paper a certain time in the future, not by far. The mechanism of CP comes from

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the promise of firm to pay the holder of the paper at some specified time in the future. If there
are restrictions like the regulated markets, then specified the obligation of firms to present a list
of their stock exchange, with a minimum capital requirement. This yields a maximum difference
between highest rated papers and junk papers to the rate of 1.5 percent. Must be mentioned that
the USA has the highest volume of CPs, and in Europe, France has the largest domestic CP
market. The certificate of deposit, known with the acronym CD, is a statement that a lender
deposited an amount of funds for a certain period of time in a certain bank at a determined rate
of interest. The difference here is that based on yield basis and not on a discount basis like the
case of the discount market and the market of commercial paper, and the reason is that the
promise of the returned money excess the year basis. Denominations in that market are very high
and the reason is the usage of a secondary market. The added advantage is that the lender has
instant access to funds by selling the CD, and according to this borrower pays with a smaller rate
of interest. The discount market, the market of commercial paper (CP), and the certificates of
deposit (CDs) show markets where the borrowing and lending is carried out through the issue of
securities which can be sold and bought in a secondary market. The interbank market is a market
for non-negotiable deposits, where the deposits, only if are not any more belong to the borrower.
Money market deposits are large bank deposits made by non-banks, which are usually
corporations of public sector or municipalities. A repurchase agreement is acceptance between
parties that the borrower must buy securities from the seller, with the obligation to resell at a
specified time and time in the future. The higher price of repurchasing is the premium of the
repurchase agreements, with the initial price to be lower than the price of repurchasing, with that
way the seller gain the difference from his purchase. (Howells and Bain 2005)

In discount markets bills come from the central government treasury, the bills issued by public
corporations, and from commercial bills. The bills of central government Treasury are known as
treasury bills, based in the UK and USA. Auctions are the mechanism where the procedure starts
and it is plausible to distinguish in two forms. The first form is the bid-price auction where
successful bidders pay the price that they bid, and the second one is the striking-price auction
where bids are ranked by descending value and the winning bidders have then the obligation to
pay the price, according to their ranking from the defining value, and all of them pay the lowest
bid, and the purpose for this is to clean the market. From money markets, treasury bills have the
lowest yield, because they are default-free and central banks discount treasury bills in cash, based
on demand, with financial institutions to supply cash on demand to their depositors using the
turn of guarantee. For the issue of commercial bill, there the function is by a promise by one firm
to pay another arranged amount at a certain time in the future. Here, the seller draws a bill on the
buyer of the goods who accepts to pay at a certain place and time in the future. The discount rate
depends from the risk of default. So comparing the commercial bills with government or public
authority bills deduce that rates of commercial bills are higher than the other two. Also on more

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factor that influence the commercial bills is the rate of how much trustful is the one part, for
instance the status of banks is generally well known, so this leads to bank bills which have lower
rates of discount than the if they had accepted by the buyer of the goods. So, highest standing
banks have an eligible bill for a discount with the central bank.

According to the case of income potential, in the case of money market funds we conclude that
we have regular payments, with variable amounts. More specific for certificates of deposits stated
at the time of issuance, and the payments are generally made monthly, semiannually, or at
maturity. Generally, for the principal is returned at the certificates of deposit’s maturity. The
meaning of the certificate of deposit is that enforce a statement where the lender has deposited a
specified quantity of funds for a specified period with a specified bank at a specified rate of
interest. For that reason is a receipt of a time deposit. So, deduce that also here exists a regular
payment. This is a market in which short-term securities are issued and traded. Bills are usually
issued with initial maturities from one to three months, six months, and, less usually, 12 months,
and for this reason applied the discount value, for standard payments. So, for the case of the
discount market exists a regular payment. Moreover, in the case of commercial paper market also
exists a regular payment. Because, in that theme a firm must pay the holder of the commercial
market paper at some specified future time, and this implies for the income potential, a regular
payment. The interbank market based on deposits, which can be disposed only by withdrawing
them from the borrower. The interest rate paid on interbank deposits represents the marginal
cost of one important source of funds for banks. But, in that case of short of liquidity, it is
plausible in the extreme case of being unable to honor customers’ cheques. So, in extreme cases
it’s plausible to have no regular payments. Also, money market deposits, pay interest at the rate
linked to interbank rate, implying that in the last two issues to have income potential, with no
regular payments. The repurchase agreements contain repurchases at some specified time, and
price in the future, implying for income potential, regular payments. (Fidelity 2015)

Comparing with bonds, also in this case the payments are regular, though amounts vary
depending on the underlying bond holdings of the fund. In the case of individual bonds, the
payments are determined by the fixed-rate bonds, which offer periodic payments, of fixed
amounts. (Howells and Bain 2005) Bonds belong to capital markets, with bonds to be debt
capital. Implying bonds we mean a form of debt, much as a bank loan is a form of debt. Unlike
bank loans, however, bonds can be traded in a market, and a bond is a debt capital market
instrument issued by a borrower, who is then required to repay to the lender the amount that
borrowed plus interest. This happens over a specified period of time. Bonds are fixed income
instruments. So bonds are considered to be those debt securities with terms to maturity of over
one year. Debt issued with a maturity of less than one year is considered to be money market
debt. There are many different types of bonds that can be issued. The most common bond is the
conventional, or plain vanilla, or bullet bond. This is a bond paying regular, annual, or semi-

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annual interest at a fixed rate over a fixed period for redemption, with the return of principal,
deducing the par value of the bond on the maturity date. Considering all other bonds as
variations of conventional bonds, we conclude that bonds for income approach offer a regular
income. (Choudhry 2006) Analyzing the case of domestic bonds the issuer of the bonds
maintains a register of current owners and pays them the coupon when it falls due, and the same
happens in the case of zero coupon bonds. Debentures secured on the assets of a firm, which
may be secured by a floating charge on the firm’s assets in general, but in this form is a possibility
a firm to be declared insolvent. So, in that case, maybe the income could be no regular. The same
could happen and to unsecured loan stocks, where the income could be no regular. Also, to
callable or puttable bonds, the income potential, are regular, but varies in different redemption
dates. The same exists for the double-dated bonds, and also here the redemption can take place
at any time between two dates, deducing that we have a regular income. For index-linked bonds
the things are different, with income to depend from the index, so the potential income to be not
regular. The same applies and for floating rate notes, where the bonds that pay coupon adjusted
in line with some other, usually short-term, interest rates. Eurobonds are bonds issued in a
currency which is not the country of issue, but keeping the basic characteristics of bonds, implies
a regular income. (Howells and Bain 2005)

The growth of money market funds is minimal, showing that the objective of a money market
fund is capital preservation, though some growth is possible. For certificates of deposit there is
none growth potential, if bought at par values and held to maturity. Certificates of deposit can be
purchased and sold in the secondary market prior to maturity at a profit, or loss. On the other
hand bond funds to their growth have the potential for capital appreciation. The individual bonds
have none growth potential, if bought at par value and held to maturity. Bonds can be purchased
and sold in the secondary market prior to maturity at a profit, or loss. (Choudhry 2006)

The price of bonds has a different interpretation in the bonds than in the instruments of money
markets. In bonds exist a division of price in clean and dirty prices. The accrued interest is the
fraction of the coupon payment which has been received since the last payment date. The market
price, incorporating accrued interest, is also known as dirty price, and deduces the position of the
bond between its coupon payment dates. The clean price can be determined if we ignore accrued
interest. In most countries, the price actually quoted for bonds is the clean price. The buyer pays
the seller at the clean price, plus an amount of accrued interest. This distinction doesn’t exist for
market prices. (Howells and Bain 2005)

The fluctuations in bonds, influenced by the inflationary expectations. Changes of this variable
cause changes in bond prices and it is difficult to predict. In the case of market instruments, the
increase of demand shock which threatens to push demand beyond its trend growth rate, then
accommodating the demand for reserves at the going rate of interest enables banks to respond
to demands for money and credit which may lead to higher inflation. So, for money markets,

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inflation seems to be the result of the problem, in contrast to the previous situation, where was
the cause. But, in both cases inflation affects the prices.

The discount market, which in short-term securities are issued and traded in a time period with
initial maturities from one to three months, six months, and, less usually, 12 months. So, in any
case is less than a year. The commercial paper market is a market where more papers issued
between 7 and 45 days. The certificated deposit market is a market where belongs to the
limitation period of one year maximum. The interbank markets have an initial maturity of the
deposits which can be ranged from overnight to one year, though shorter maturities to be the
more popular. The money market deposits are usually for seven days, though sometimes longer.
The repurchase agreement is an agreement to buy securities from a seller on the understanding
that they will be repurchased at a certain time in the future, with a period less than one year.
(Howells and Bain 2005)On the other hand, the bond period exceeds more than one year.
(Howells and Bain 2005)

In the case of money market funds the anticipation is to protect your principal, but they are not
insured and do not come with any guarantee. You can buy or sell shares in a money market fund
daily. The principal is insured against if bank failure, and most brokered certificates of deposit
can be bought and sold prior to maturity at a profit, or loss, although the secondary market may
be limited. The bond funds do not have a maturity date, so it is plausible to principal to be
fluctuate, and funds can be bought and sold daily. (Fidelity 2015)

The fees or expense ratios in money market funds are for instance 0.19%-0.55% in the gross
expense ratio per year in the U.S. and for certificates of deposits, are no fees for newer issues. In
the case of bond funds, there are mutual funds charge a fee represented by the expense ratio,
which reflects operating expenses expressed as a percentage of the fund’s average net assets. For
individual bonds, there exists an online secondary treasury purchases which are free, and other
bonds purchased on the secondary market, which are for paradigm in the U.S. approximately
equal to 1$ per bond. Money market funds have as minimum investment for the example of the
U.S. economy, it is approximately between 2,500$ to 10 million dollars. Basically assets generally
concentrate on high quality, short-term money market securities. In the case of certificates of
deposit the minimum investment is 1,000$ using as paradigm the U.S. economy. On the other
hand bond funds have as minimum investments the amounts of 2,500$ to $10,000. Bond funds
are portfolios of bonds, which can offer broad diversification, though some funds are intensively
focused. In the individual bonds, the minimum investment is 1,000$ to 5,000$, according to the
kind of issued bond. The first factor that affects the prices of money markets is the return of a
loan like in the case of interbank deposits, the size of the risk like in the case of repurchase
agreements, the stock exchange and the credit rating defines the price in money market
instruments like the commercial paper market. (Howells and Bain 2005) On the other hand,
bonds influenced by risk, and interest rates. And, risk with its turn affected by the state of the

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economic cycle, the firm-specific events, and the state of government finances. And interest
rates, which affect bonds, imposed by inflation, monetary growth, exchange rate, government
borrowing and overseas interest rates. (Howell and Bain 2007)

Financial markets contribute industries with the use of money market and help the industries in
securing short-term loans to meet their working capital requirements. The way that financial
markets achieve that is through discount market, with Treasury bills, local authority/utility bills,
commercial papers, the market for commercial paper, the certificate of deposit market, the
interbank market, the money market deposits, and the repurchase agreements. On the other
hand, industries need long-term loans, which are provided in the capital market. However, capital
market depends on the conditions in the money market. Hence, the short-term interest rates of
money market influence the long-term interest rates of the capital market. Thus, money market
with no direct impulse helps the industries through the influence on long-term capital market. So,
and bonds help financing industry, but money markets influence indirectly, capital markets, and
with that way bonds of financing industry. (Sinha 2015) Long-term debt instruments have
substantial interest-rate risk. On the other hand, short-term debt instruments do not have quite
interest-rate risk. To be more precisely bonds with a maturity that is as short as the holding
period have no interest-rate risk. No interest-rate for any bond whose time to maturity matches
the holding period is to recognize that the price at the end of the holding period is already fixed
at the face value. According to that the change in interest rates can then have no effect on the
price at the end of the holding period for these bonds, and the return will be equal to the yield to
maturity known at the time the bond is purchased.

3. Monetary policy in Money Markets and in Bond Markets

The monetary policy of a country is the process by which the central monetary authority,
controls the supply of money in the economy. This is primarily done by targeting a particular
interest rate for achieving economic growth and stability, controlling inflation, and reducing
unemployment. For this reason the target of monetary policy is to retain prices constant.
Analysing, a monetary policy can be expansionary or contractionary. An expansionary policy is
the case where increases the total supply of money in the economy more rapidly than usual. Such
measures are usually used to combat unemployment in a recession by lowering interest rates
in the hope that easy credit will entice businesses into expanding. A contractionary policy
expands the money supply more slowly than usual or even shrinks it. Such a measure is intended
to slow inflation in order to avoid the resulting distortions and deterioration of asset values. We
must note that a monetary policy differs from a fiscal policy, which refers to taxation,
government spending, and associated borrowing. It is the monetary policy that influences the
slope of the yield curve. A tightening of the monetary policy usually means a rise in short-
term interest rates, typically intended to lead to a reduction in inflationary pressures. When those

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pressures subside, it is expected that a policy easing, that is lower rates, will follow. Whereas
short-term interest rates are relatively high as a result of the tightening, long-term rates tend to
reflect longer term expectations and rise by less than short-term rates. The monetary
tightening both slows down the economy and flattens the yield curve. The effect of a
monetary tightening, will lead to rise in short-term rates, is also reflected in the performance of
short-term Treasury bonds. In a rising rate environment, certain investors prefer short-term
Treassury that are designed to play rising interest rates, which tracks floating rate debt of
companies. When it comes to changes in the shape of the yield curve, there is no bigger factor
driving these changes than the central bank. However, the actions of the central bank affect
short-term interest rates differently compared to long-term interest rates. Monetary policy can
affect the slope of the yield curve. A tightening of monetary policy, usually means a rise
in short-term interest rates, typically intended to lead to a reduction in inflationary
pressures. When those pressures subside, it is expected that a policy easing will follow. Whereas
short-term interest rates are relatively high as a result of the tightening, long term rates tend to
reflect longer term expectations and rise by less than short-term rates. The monetary tightening
both slows down the economy and flattens the yield curve or causes an inversion. Then, there is
inflation expectation that can play a large role in setting yields for longer dated bonds. If
inflation expectation is high in future, an investor in a bond will require a higher yield to secure
the time value of their money locked in for the length of maturity. Therefore, on the onset of
high inflation, a longer dated bond’s yield spikes up where as a shorter one does not move up
as much leading to steepening of yield curves. According to business cycle also influences the
shape of a yield curve. The yield curve tends to steepen during the early stages of a
macroeconomic downturn and flatten during the recovery stages. So according to that may invert
near the peak of an expansion. The yields available for shorter-term Treasury securities it is
plausible temporarily exceed the yields available for longer-term Treasury securities. In the case
of money markets, there one official way to affect the money markets is through the official
intervention in the money markets expressed by a number of techniques that the monetary
authorities use to impose the rate of growth of bank supply deducing money supply. The
techniques are two and these are the direct and the indirect controls. The direct control means
quantity controls and the indirect means the market-based controls. Market-based means that
the short-term interest rates, allowing the market to determine the quantity and to influence the
money and credit. Money markets connect with interest rate in short-term conditions, and
some involvement must exist between official interventions in the money markets. The
issue is how intervention imposes the attitude in the money markets. In any case central band
uses its advantage as the monopoly supplier of bank reserves through the open market
operations. The central banks structure of its function based on the default interest rate that
chooses for all short-term rates. But the deviations that imply through this process diminish

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through the supply whatever quantity of reserve banks require. This quantity is perfectly elastic as
to be adjusted to the demanding quantity of reserves banks require. The value that is perfectly
elastic is the magnitude of interest rate that central bank requires. The other case is the issue of
the quantity, to maintain constant. In that form if the demand increases, then interest rate
increases to maintain the quantity of reserves the same. And to the opposite approach if demand
declines, then the result will be to diminish the interest rate the central bank to keep the same
volume the reserves.

Debt has a much longer maturity, so the automatic increase is a function of average interest rates
over a period of years. Debt sustainability is that between interest rates and growth, either in
nominal or real terms. If growth is low and depressed, relative to interest rates, then the debt will
become unsustainable, unless there is a commensurately large primary surplus. But trying to
achieve a large primary surplus, via austerity, especially when everyone else is trying to do the
same thing, is likely to reduce growth still further, and just add unemployment. For current
expectations and real interest rates that are given, the scale of the public sector surplus is
bounded, then the price level has to rise sufficiently to make the general public prepared to
absorb the stock of public sector debt that must be sold. This is, the fiscal theory of the price
level, and that way leads to hyperinflation, as expectations adjust fast. increases in nominal
interest rates, relative to growth, if maintained for any long period of time are likely to force the
debtor either to default, or, perhaps consciously, to inflate the debt away. Moreover we must
note that the yield curve is inverted when short-term interest rates are higher than long-term
interest rates. The yield curve inversion usually takes place before the start of the recession. The
peak in the stock market comes approximately the time of the yield curve inversion, ahead of the
recession and accompanying downturn in corporate profits.The central bank has been signaling
that tighter monetary policy is on its way, which means short-term interest rates should move
higher. So must push up short-term rates before the yield curve inverts depends on where long-
term rates are. Even if long-term rates stay at the very low yield, to invert the yield curve would
need to hike short-term rates.The choice of policy that central bank determines connects with the
economic situation. For instance, if the demand increases from demand shock, then maybe the
result could be the increase of inflation, if this depends from accommodating reserves, which
follow the shock demand then and on the other hand, if this demand caused by financial
innovation maybe then the constant reserves cause increase of interest and that causes deflation
upon the real economy. Central banks in practice prefer between the two methods to set the
price, with the market-based method than to use the method of quantity. So the most common
technique of central banks is the market-based method and according to that they control the
short-term interest rates. This technique allows a variance to the quantity of reserves. So, the
changes in short-term rates impose two variables, the price of loans and the quantity demanded.
Moreover, the issue of the relation between the rates of money, from the influence of rate, causes

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transformation to the magnitude of money demanded. This is deduced a change in exchange
rates via capital flows. Central banks are the last resort as lenders. Also, central banks are basically
monopoly suppliers of liquidity in any economic system. In the case of market-based approach
banks must increase their reserves through the increasing demand. The increasing demand of
banks for reserves implies a short-term borrowing from the central bank. The key point for the
market-based approach is that central banks set the rate. The functions that a central bank can
admit are the open market operations and the discount window method, which is in a common
practice in the United States, with the banks to borrow directly through the central bank. And the
alternative method is to enter directly the central bank to money markets and buy or sell by its
self. This is the open market operations, characterized by the potentiality of central banks to buy
or sell securities in markets, approaching all participants. Increase in interest rate, for example, it
is plausible to happen by the offer of central banks to buy treasury or eligible commercial bills at
a lower price than it did to the last offer to buy. If the central bank wants to send the message
that interest rates wishes to stay at the same level, it offers to deal at current prices. The Paradigm
of Germany (Fisher 1996) with the decrease of securities repurchase (repo) rate, had an impact in
money market, from 3.3 per cent to 3 per cent, influenced the growth in the money supply. The
imposing was the increase of money market instruments, with these instruments to have a
proportional behavior of bonds and shares. The unexpected nature of the reduction effected
markets. And in addition the impact of this announcement was worldwide. The technical
approach of central banks to achieve an increase in interest rates it is possible by the increase of
its own lending rate, but sometimes this method does not work because there is not enough
liquidity in the market. This is the reason that many countries, like the paradigm of France
preferred to move forward from the discount window to open markets with a purpose to avoid
these deviations. The only mechanism that worked in sufficient way was the short-term interest,
with the combination of money market intervention. For instance the way that a central bank
functioning like the case of the Bank of England there the central bank makes twice-daily
forecasts of the money markets likely liquidity position. If the forecasts show an expansion, the
Bank states outright purchases of assets and enter into repurchase agreements up to the volume
of lack of reservations for a short-term period, after each forecast. The assets in which the Bank
of England makes outright purchases are treasury bills and eligible bank and local authority bills.
The deals between institutions and institutions have to meet specified characteristics. The assets
in which transactions are in most cases with very short-term less than fifteen days. For outright
purchases the residual maturity invariably is less than fourteen days, like the case of repos. The
outright purchases and repos are useful for the adjustment to liquidity shortages, or, surpluses.
But, for monetary purposes, if the Monetary Policy Committee decides to make a monetary
change in economic policy, then a change in interest rates caused to serve that issue. The most
important feature of the money markets is that central banks have the sovereign role and they

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can determine the short-term interest rates. (Howells and Bain 2005) The central bank can
attempt to control inflation or deflation by engaging in open-market operations. In open-market
operations, the central bank buys or sells government securities on the open market to change
the rate of growth in the country's money supply. A change in the country's money supply affects
the general price level in an economy.

Changes in the exchange rate are transmitted to the economy in the following ways. First, the
exchange rate acts directly to dampen imported inflationary pressures. Domestic prices are very
sensitive to world prices. The exchange rate thus provides an important buffer against external
price pressures at the borders, especially in periods of escalating global commodity prices, thereby
contributing significantly to the objective of medium-term price stability. Second, the exchange
rate acts indirectly to tackle domestic sources of inflation. A stronger currency moderates the
external demand for our goods and services, and as the demand for domestic factor inputs eases,
factor incomes rise more modestly. This in turn reduces the domestic demand for non-tradable
goods and services, and puts downward pressure on prices. If the government wants to slow
down the rate prices which are increasing, it will decrease the supply of money in the economy by
selling government securities. When a government sells securities, such as Treasury bonds, it is
taking money out of the economy and replacing it with government securities. If there is less
money in the economy, interest rates will tend to increase, as borrowers have to compete for
loanable funds. Some borrowers will decide not to borrow money if interests rates hit a certain
level, which results in a decrease in demand. As demand decreases, sellers will produce less and
will not increase prices as they attempt to induce consumers to buy their products. Eventually the
supply of money will equal the demand for it and prices will stabilize. The central bank can also
try to stop decreasing prices by use of open-market transactions. Instead of selling government
securities, it will buy them back, trading money for securities. This will increase the money supply
and tend to reduce interest rates as lenders compete for borrowers. Demand will increase because
of the increased availability of money, which will induce sellers to increase production and
increase their prices to gain more profit from the demand. Eventually, the demand for money
will equal the supply of it and the general price level will stabilize. Analyzing, for instance, in the
case of European markets and ECB, is that the continued integration and deepening of financial
markets is a significant issue for policy-makers, and particularly for central bankers, since
smoothly functioning and efficient financial markets are crucial in ensuring a smooth
transmission of monetary impacts. The monetary policy can make smooth functioning and
integration for the case of European financial markets and to economic growth is to maintain a
steady medium-term price stability policy. According to that will minimize the adverse effects of
inflation and high inflation. The application of price stability it creates conditions for higher
economic activity over the medium term, and simultaneously reduces the economic and social
inequalities caused by the asymmetric distribution of the costs of inflation among the various

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economic agents. Moreover, for the case of low inflationary expectations, inflation risk premia
become less important as a determinant of financial prices. We conclude that other factors such
as credit risk states an important impact in the price formation mechanism. This settlement is an
efficient allocation of financial resources. The approach of focusing on price stability is by now
the conventional wisdom in industrialized countries. In the case of Europe, the contribution of
price stability in the medium term to promoting long-term growth keeps in the ESCB, which
provides that the primary aim of the ESCB shall be to maintain price stability in the medium
term. Monetary policy offers its maximum to the realization of strong output growth and to the
satisfaction of serving employment targets.(Duisenberg 2001) Inverting, interpreting the way that
money markets influence the Central Bank happens with a form that the existence of a developed
money market smoothens the system that operates the efficiency of the Central Bank. Money
markets help the central bank in the short-run with interest rates of the money market to serve as
an indicator of the monetary policy to guide the central bank to adopt an appropriate banking
policy. The sensitive and integrated money market helps the central bank to secure quick and
widespread influence on the sub-markets, and according to that it is plausible to achieve an
effective implementation of its policy. (Sinha 2015)

In the case of government bonds, the sale and redemption of primary markets are an important
instrument of monetary policy and the government needs to be specified that it wishes can be
made effective in the market, for government bonds. The Debt Management Office retains the
unsold stock and releases it onto the market subsequently, when conditions permit. According to
the most known case the debt Management Office is an agency in the UK Treasury and manages
government debt. This stock is generally known as tap stock. Moreover, another method for
administration of bonds through monetary policy involves the auction of stock, in which no
minimum price is set. According to that method the stock is sold to the highest bidders at the
price they bid. This method focuses monetary policy influenced by the point of view where
money supply and credit aggregates, sales by auction have the advantage that the issuer can set
the volume, since the price adjusted. By bidding the price is set, with the result to be that the
volume of sales becomes uncertain. One more method is to buy the Debt Management Office
the stock and release it when conditions admit. In addition the Central Bank could keep a small
proportion of bonds, and for long-term government bonds, initially offered at a fixed price issue.
The remainder then subsequently sold at auction to anyone who cares to bid. In the case of
medium term bonds are sold to a network of financial institutions as market conditions permit,
and the short term is sold by auction. The function of monetary policy in the case of a perfect
capital market, with characteristics, like perfect information, no taxes, bullet maturity bonds, and
no transaction costs. Using the yield, then the graph plots the yield of various bonds against their
term to maturity, showing a snapshot of the current level of yields in the market. The impact of
short-term interest rates is greatly influenced by the availability of funds in the money market.

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According to the slope of the yield curve determines the degree of tightness of government
monetary policy. The low, upward-sloping curve is often considered to interpret as cheap money
as a settlement of loose monetary policy, and is the next step after a maturity of higher bond
yields and higher inflation. On the contrary a high downward-sloping curve is taken to interpret
tight credit, as a result of strict monetary policy, after the settlement of lower bond yields and
falling inflation. As an example the case of the US recession had a negative yield curve. The
interpretation is that investors expect a recession where inflation falls, and according to that
yields on long-term bonds also fall relative to short-term bonds. According to that one would
expect the regulatory authorities to ease the money supply by reducing the base interest rate in
the near future, implying inverted curve. The result in that case would be a reduction of short-
term interest rates to affect short-dated bonds, and these are sold by investors, with a result to
raise their yield. The determination of downward sloping or inverted or negative yield is the case
where long-term yields are significantly lower than short rates. On the contrast upward or
upward sloping or positive or rising is the case where yields are at historically low levels, with
long rates substantially greater than short rates. Government policy with the monetary policy
determines the shape and the level of the yield curve, through the policy influence the debt
management and the open-market operations. The conception of the market’s size of public
sector debt will influence bond yields. So, an increase in the level of debt it is plausible to lead to
an increase across the maturity range. Open-market operations, which are connected with the
daily operation of the Bank of England to control the level of the money supply in the short-term
can, reform the yield of the base rate effecting yield levels. A rise in the base rates can lead to a
drop in prices for short-term bonds, because one could expect yields to rise, and according to
that it is plausible to lead to a temporarily inverted curve. (Choudhry 2006) Changes in interest
rates have important effects on individuals, financial institutions, businesses and the overall
economy, with the month Treasury bill rate to move together. Different interest rates have a
tendency to move in unison with interest rates. For instance, in the case of the UK for the period
between years 1973 and 2008 we have that interest rates on several types of financial instruments
can differ substantially. The conclusion is that the interest rate on three-month Treasury bills
fluctuates more than the other interest rates and is lower, on average. In UKs instance the
interest on a 10-year bonds is the interest rate on a 10-year bonds, which follow the same pattern
as long-term government bonds. These types of bonds are referred to as consols. Both 10-year
bond rates, and consol rates fluctuate less than the Treasury bill rate, but are higher on average,
than the Treasury bill rate. Must be declared that 10-year bonds are the interest rate on UK
government bonds that have maturity of 10 years. We conclude that applying the monetary policy
long-term bonds fluctuated less than Treasury bills. We normally assume that interest rates must
always be positive. Negative interest rates imply that interest rates would imply that the willing is
to pay more for a bond today, because the receiving in the future. So, negative interest rates seem

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like an impossibility because you would do better by holding cash that has the same value in the
future as it does today. As paradigm in November of 1998, interest rate on Japan, the six-month
Treasury bills became negative, showing that the weakness of the economy and quality purposes
during a financial crisis can lead interest rates to low levels. The negative interest rates could be
explained as large investors found it more convenient to hold Treasury bills as a store of value
rather than holding cash because the bills are denominated in larger amounts, and can be stored
electronically. (Mishkin, Matthews and Giuliodori 2015)

4. Epilogue

Here to that assignment are represented extensively the differences between money markets and
bond markets using basically the yield curve. In addition the monetary policy depends from the
sticky prices, the exchange currency, and the currency rules. In order to achieve this objective
targets it takes into consideration the budgetary situation. Moreover, it takes into account and
monetary factors as the existing level of prices, the exchange equivalence and the expectations
that exist for this change, so that it will be supposed it influences the interest-rates, in order to
shape the balance between offer and demand of money that is desirable. Monetary factors are
influenced by the yield curve and the monetary policy which influence the expectations that
determine the form of yield curve.

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