Money and banking question?

Economics Question (Money and Banking course)?

• If higher money growth is associated with higher future inflation, and if announced money growth turns out to be extremely high but is still less than market expected, what do you think would happen to long-term bond prices? Thank you much!

• Answer:

  Ok, let's see. If higher money growth was due to interest rates cuts, but still market wants more money, then probably the Central bank will cut interest rates even more. Lower interest rates means lower bond interest, thus higher bond price. When prevailing interest rates fall, newly issued bonds typically offer lower yields to keep pace. When that happens, existing bonds with lower coupon rates becomes more appealing to investors. Thus lower interest rates mean higher prices for existing bonds. Also, we have to take into account inflation. Higher money growth means higher inflation. Inflation has the same effect as interest rates. When the inflation rate rises, the price of a bond tends to drop, because the bond may not be paying enough interest to stay ahead of inflation. Remember that a bond's coupon rate is generally unchanged for the life of the bond. The longer a bond's maturity, the more chance that inflation will rise rapidly at some point and lower the bond's price. That's one reason bonds with a long maturity offer somewhat higher interest rates: they need to do so to attract buyers who otherwise would fear a rising inflation rate. (Another reason is that buyers want a higher interest rate if they are going to tie up their money longer.) Thus, bond prices will get higher. Of course, in order to be sure about the effect, we need an econometric analysis. The existence of a causal relationship between changes in money growth and changes in both the inflation rate and the nominal interest rate is generally acknowledged. However, less agreement exists on the timing and magnitude of the response of inflation and the nominal interest rate to money shocks. Many economists believe that a positive shock to money growth brings about two opposing effects on the nominal interest rate. The first, known as the liquidity effect, is the fall in the nominal interest rate necessary to induce agents to hold additional real money balances. The second, known as the anticipated inflation effect, is the rise in the nominal interest rate due to the increase in expected inflation brought about by the increase in money growth. In the short run, it is often argued that the liquidity effect dominates the anticipated inflation effect. There is less agreement on the long-run effect of money shocks on interest rates. I hope this helps