Economics is an important subject because it helps people to understand different issues relating to their day-to-day life, for example, borrowing, spending, investing, and allocating resources. However, it is important to understand various issues referring to economics for one to make suitable decisions in economic activities. The main focus of the paper is a discussion of different topics relating to economic issues.
Reasons for Higher Yields in Risky Bonds
Risky bonds refer to the bonds provided by the bond issuer to the bondholder without any collateral. They are termed risky because they are not secured by collateral. The lack of the collateral increases the chance of the payment default, making it risky (Becker and Ivashina 1868). Despite the risk of losing the principal and the interest in the case of the payment default, the risky bond has high yields.
The main reason for a higher yield in risky bonds relates to the total amount realized from all coupon payments. Once the bond is purchased by the bondholder from the bond issuer, the latter is expected to make periodic payments, coupon payments, to the former. Considering the fact that coupon payments are made in addition to the interest, the bondholder can earn high returns once all the payments are completed. The lack of a collateral requirement in risky bonds attracts many bond issuers (Becker and Ivashina 1870). An increased number of issuers means that the bondholders can enjoy high returns once the principal and the interest are received from the issuers. Another reason for higher yields in risky bonds relates to built-in price appreciation. Once the bond issuer issues the bond to the bondholder, the bond is allowed to mature to attain the par value, meaning that the amount that will be paid back to the bondholder by the issuer depends on the function of the integrated price appreciation (Becker and Ivashina 1875). Thus, risky bonds will attract higher yields compared to secured bonds.
The collaterals help in lowering the number of risks in risky bonds. As a result, the arrangement of coupon payments is affected. Additionally, the function of the integrated price appreciation is affected, as well, which contributes to the reduction of the amount of yield in risky bonds (Becker and Ivashina 1879).
Volatility of Long-Term and Short-Term Bonds
The main reason for less volatility in long-term bonds in comparison to short-term bonds relates to the time to maturity of the bond. It is important to note that when the time to maturity increases, the sensitivity of the bonds to the change of the interest rate increases, as well (Goyenko and Ukhov 190). It means that short-term bonds are less sensitive to the change in interest rates compared to long-term bonds. A good example to explain this assertion is that money invested in short-term bonds can be reinvested using the new interest rate while money in long-term bonds is tied to the existing interest rate for a longer period (Goyenko and Ukhov 202).
According to Goyenko and Ukhov, changes in interest rates in short-term bonds are usually made more regularly with an aim of preventing inflationary or deflationary situations in the economy. The changes are regarded as a microeconomic measure, which is effective in short-term bonds. The interest rate in long-term bonds involves interest rate on securities, for example, 20-year bonds. Long-term bonds influence the interest rates to reflect the long-term market expectations of inflation, which creates a situation where long-term bonds tend to be less volatile as compared to short-term bonds.
Another reason that makes the long-term bond less volatile compared to short-term bonds relates to the fact that there is a higher possibility that the interest rate will change within the extended period than within a shorter period. Thus, people willing to sell long-term bonds before maturity are likely to face discounted market prices (Goyenko and Ukhov 211). The higher volatility in short-term bonds relates to the short period involved for the issuer to return the principal. In short-term bonds, the issuer of the bond is allowed less time to pay back the principal as compared to long-term bonds.
Effect of the Central Bank on the Economy
The central bank of any country can affect the economy of the state because it can regulate the monetary system and ensure the stability of the country’s financial system. There are several ways in which the central bank can affect the economy, including monetary and fiscal policies.
Through monetary policy, the central bank can influence the money supply in the economy (Maheshwari 176). To increase the money supply in the economy, central banks set the interest rates to ensure that commercial banks and other lending institutions offer loans to customers at low interest rates (Maheshwari 176). This policy encourages people to borrow money and invest it in various projects. As a result, one can observe an increase in economic activities because individuals can start new businesses and invest in development projects, which results in creating new employment opportunities. People who are employed in new businesses can earn income, which increases their purchasing power, meaning that they can acquire various products and services in the market. As a result, they contribute to the growth of the businesses, which in turns leads to the growth of the economy. Additionally, the central bank can raise the interest rate with an aim of reducing the inflation in the economy.
Moreover, the central bank can use the fiscal policy to influence the government spending and regulate taxation policies (Maheshwari 176). To increase economic activities in the country through the fiscal policy, the central bank increases the government spending to ensure that there is more money in various sectors of the economy. The central bank can also reduce taxes to promote the growth of businesses in the state. These actions lead to increased economic activities, which can influence the growth of the economy. The central bank can also reduce government spending and raise tax rates, which will reduce the money supply in the economy, leading to a slow growth of the economy.
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Monetary Policy and Exchange Rates
The exchange rate refers to the rate at which the currency of one country can be exchanged for the currency of another state. A high exchange rate for a particular currency makes the foreign currency cheaper, which results in cheap import. On the other hand, a low exchange rate makes the foreign currency expensive. In this case, the imports become expensive because more currency is required to buy foreign currency.
Monetary policy can influence the exchange rate because it can change the money supply and credit availability (Devereux, Lane, and Xu 479). Furthermore, the monetary policy can influence the exchange rates through prices and income. Through the monetary policy, it is possible to increase the money supply in the economy, thus making the credit cheaper (Devereux, Lane, and Xu 481). When individuals receive a credit from the bank or other lending institution, they can invest it and increase their income. The increase in individual income makes it possible for one to spend on the imports. When a particular currency, for example, the U.S. dollar, is used to buy another currency to acquire the required imports, its exchange rate decreases. On the other hand, when the contractionary monetary policy is employed, the money supply and the level of income fall (Devereux, Lane, and Xu 492). This reduces the demand for the foreign exchange and, as a result, increases the exchange rate of the currency of a particular country.
To expand the country’s economy, the money supply is increased through the monetary policy. Increased money supply leads to an increase in prices of various products and services (Devereux, Lane, and Xu 494). Increased prices make import cheaper and export more expensive, which creates a situation where the country spends more money on import. This leads to an increase in demand for foreign currency, which in turn lowers the exchange rate of the country’s currency (Devereux, Lane, and Xu 497).
Central Bank and Increase in Interest Rate
The central bank of any country employs various tools, including the interest rates, to influence the money supply in the economy. It can increase the interest rate without reducing the size of reserves through the sale of government bonds. Once the central bank sells the government bonds to the individuals, it reduces the amount of money in the economy (Woodford 15). With the less money in the economy, the interest rates increase.
The main reason for increasing the interest rate without decreasing the size of the reserve relates to the need of stimulating the economic growth and reducing inflation in the economy (Woodford 17). Increasing the interest rates assists in reducing the cost of living and doing business, which encourages more people to start new businesses in the country. An increase in new businesses helps to solve the problem of unemployment (Woodford 17). Creation of new jobs helps people to earn income, which in turn allows them to buy various products and services. Consequently, this raises the demand for various products and services, which encourages increased production in various sectors and leads to the growth of the economy.
The central bank also increases the interest rate to reduce the inflation in the economy. By increasing the interest rate, the central bank can reduce the amount of money in the economy, which creates a situation where people reduce the amount of money they spend on buying goods and services (Woodford 18). Reduction of purchasing power leads to the decrease in the price of various items and services. Thus, through increasing the interest rate, the central bank can reduce the rate of inflation.
Changes in Exchange Rates and Inflation Rate Differentials
The exchange rate refers to the prices that are determined by the demand and supply. In most countries, the exchange rate is important to the economy because it regulates the international balance of payment. The fact that an economy with high inflation has a high interest rate helps to explain that long-run changes in exchange rates are tied to inflation rate differentials.
The inflation rate refers to the rate at which the general level of prices has increased during a given period. In the long-run, the change in interest rates is tied to inflation rate differentials because the change in interest rates can influence the amount of money in the economy. A rise in the exchange rate of a particular currency leads to a decreased rate of the foreign currency, which makes the import cheaper (Agarwal 321). As a result, less money is spent on import. Considering the fact that less money is spent on import, there is much money left in the country’s economy. An increased supply of money in the economy leads to an increased level of inflation.
On the other hand, a decrease in the exchange rate of a particular currency leads to the rise of the exchange rate of the foreign currency (Agarwal 321). A high exchange rate of the foreign currency makes the import more expensive, which creates a situation where more money is spent on imports. As more money is spent on import, the money supply in the economy is reduced. Additionally, the high cost of import leads to the increase in prices of various goods and services. Considering the fact that most people lack enough money to spend, they are unable to secure their needs. Thus, the demand for goods and services decreases, which, in turn, leads to the decrease in prices.