Explain how interest rates and bond prices are related to one another. Why is this important for monetary policy?

Answer 1

Interest rates and bond prices are inversely related; when one increases, the other automatically decreases. The reason for this is that bonds pay a specified amount of money per year as interest and this amount does not change after the bond has been issued. If bond prices fall, then the effective rate of interest increases since the payment amount remains the same. The relationship is important for monetary policy because the principal tool of monetary policy is the open market purchase and sale of government securities. When the Fed sells government securities (bonds) the price of bonds will fall, and therefore, interest rates would rise. The price of bonds has to fall to make the bonds attractive to buyers. Conversely, when the Fed purchases bonds, the price of bonds will be bid up and the effective rate of interest will fall. Higher interest rates are usually associated with a decrease in the money supply and lower interest rates are usually associated with increases in the money supply.