FREQUENTLY ASKED QUESTIONS
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 etc.
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 occurs inflation.
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 dramatically.
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 operation.
DEFLATION
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: Monetary policy is of two types. They are expansionary monetary policy and
tightening monetary policy
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
Deficit 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 economy.
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.
Surplus Budget
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 economy.
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 ECONOMIC GROWTH?
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
as follows:
• Inflation targeting
• Monetary aggregate
• Fixed exchange rate
• Mixed policy
Inflation targeting
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.
Monetary aggregates
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.
Mixed Policy
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 follows:
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.
WHERE TO PUT MONEY?
October 1, 2006: Money should not be kept idle. Once we have some extra money, we need to invest it
so that we can generate some extra income out of it. Generally assets are of two types. They are
financial assets and real assets. Examples of the financial assets are stock, bond, mutual fund, fixed
deposit etc while real assets are land, house, car etc. This section will discuss primarily about the
prospects and challenges that are linked with financial
assets.
First of all, we need to buy some books on investment issue and acquire some basic knowledge about
stock, bond, mutual fund, fixed deposit account etc. In addition to that, we can talk to a financial planner
to exchange our views and acquire knowledge before investing money. Many companies in recent days
provide free financial advice for us. Companies who are issuing bond and stock usually publish their
prospectus where we can see all their activities including asset and liability of the company, sale volume,
nature of the business etc. We can indeed gather knowledge from the prospectus.
As said, there are a number of financial instruments that are available in the financial market for our
money gets invested. The most popular financial instruments are stock, bond, mutual fund and fixed
deposits. Before deciding of the investment, first of all, we will have to know what type of person we are.
Are we risk lover? Can we invest money for long term?
If we want to have higher total return from financial assets, we will have to invest money in stock but
investment must be made for a long term. Experiences and statistics suggest that total return from
stocks is higher than any other financial instruments but money must be parked for a long term in that
particular stock portfolio. Stock portfolio is an accumulation of stocks that you are holding. Best
suggestion is to buy all blue chips and keep it for next 10 years.
Total return from the bond is guaranteed if you can hold the bond until maturity. Investment in bond is less
risky compared to stock as the interest and principle payment by the bond issuer is guaranteed. But total
return from bond is lower than stock, on average.
When the Central Bank increases interest rate to take the excess money out from the financial system to
tackle inflation, prices of stock go down due to shortage of money supply in the financial system. This is
the best time to buy stocks. Our profit always lies with the purchase. If we can purchase at lower price,
profit is almost certain. On the other hand, yield of the bond goes up with the interest hike. When the
bond yield goes up, price of the bond always goes down. In this case, we can hold the bond until maturity
to get interest (coupon rate) plus principle. The best suggestion is to keep the bond until maturity and
meanwhile we can enjoy higher yield. Indeed, there exists an opposite relationship between price of the
bond and its yield.
When the Central Bank reduces the interest rate in the economy to tackle recession, money supply
increases in the financial system. This increased money supply enhances demand for stock and hence
stock prices shoot up. This is not good time to purchase stock but good time to sale. On the other hand,
due to low interest rate, yield of the bond goes down while price of the bond goes up. We better sale the
bond now at higher prices and reinvest the money in a higher yielding bond.
Central Banks around the world are maintaining foreign reserve to defend their currencies as well as to
take part in international trade. Suppose the Central Bank of Malaysia is currently holding about US $80
billion as foreign reserve. The largest portion of this foreign reserve is invested in US treasury securities
(bond). Not only Malaysia, the largest portion of the Asian foreign reserve is invested in US treasury
securities. Why US treasury securities? because the US government has never been defaulted to pay
the money back as soon as the securities get matured. Investment in the US treasury security is the
safest in the world. The Federal government of the United States borrows money through securities
(bond) to meet its deficit, which is very common in the years of American history.
So, when the US currency depreciates, the value of the US treasury security (bond), kept by the Asian
Central Banks gets squeezed. In recent years, US dollar is depreciating against all major currencies. As
a result, Asian Central Banks are confused whether they should keep reserve in dollar denominated
security (bond). With the dropping US dollar value, investment in US treasury may get squeezed. The
reduction in investment is likely to affect adversely the capital account balance of the United States. As
for information, US is always experiencing a huge current account deficit and this deficit is largely met by
the surplus of the capital count balance since long.
So if the US dollar continues to have a very steady decline, we should not put our money is US dollar
denominated security or bond. Since United States is a potential economy, its dollar value will not
continue to fall and its value is likely to shoot up in near future. Current sluggishness in dollar value may
be a temporary one.
There are prevailing a number of financial agencies/companies, who are grading bond issuing
companies or grading on a particular bond time to time. Investor can purchase bond on the basis of the
grading rate. Historically, we have observed that established companies are paying lower interest rate
compared to newly growing companies against their bonds. Although interest income paid by the
established companies is low, they have stability and credibility. Amount of interest income is not
important. Important is its ability to pay interest and principle. Established companies or bonds are
usually enjoy higher grading rate given by Moody, Standard and
Poor etc
If we buy or sale stock or bond from the market, we need to pay fees to brokerage house meaning that
our return gets squeezed with this payment. To avoid this cost, we can invest money in mutual fund.
Mutual fund is a fund which consists of various types of financial instruments ranging from stock, bond to
fixed deposit. Various types of financial instruments are accumulated to diversify the investment in order
to spread risk. Mutual fund is managed by a group of fund managers who use their expertise and
experiences to invest our money in various financial instruments. The good news lies here, we do not
need to pay any brokerage charge to sale or buy our financial instruments once we become a member
of a mutual fund. The money invested in mutual fund can be converted to cash any time. At the same
time, money or profit can be reinvested without any fees.
The most secured investment is to put the money in a fixed deposit account. If we are risk averse, we
can put our entire saving in fixed deposit account and continue to enjoy return. But the return from fixed
deposit is lower than bond and stock. In other words, lower the risk attached with financial instruments,
lower the return is expected and vice versa.
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Email: sayed.hossain@yahoo.com
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