Term Structure of Interest Rate

Topics: Monetary policy, Inflation, Central bank Pages: 4 (1597 words) Published: December 29, 2012
WITH REFERENCE TO THE UK EXPLAIN THE CONCEPT OF THE TERM STRUCTURE OF INTEREST? WHAT INFLUENCE DOES THE BANK OF ENGLAND HAVE OVER THE TERM STRUCTURE AND WHY IS IT IMPORTANT FOR MONETARY POLICY

To understand the term structure of interest rate we need to elaborate how interest rates function and how they are determined. Interest rates are a vital tool to all the macro-economic policy objectives of a government such as control of inflation, investment as well as employment. Interest rates refer to the price paid by deficit agents for borrowing funds from the surplus agents. A line that plots interest rate at a set point in time is the term structure or yield curve. Interest rates which may be short term or long term are linked to a government’s macro-economic policy and future expectations of such a policy .The UK government uses Treasury bill and bond prices to implement its monetary policy. Bills, which are securities of less than one year until maturity show that there is an inverse relationship between their price and short-term interest rates. Bonds, which are securities of more than one year to maturity also, have the same relationship to interest rates of short- or long –term. Due to the nature of maturity, bonds are more risky than bills. If bond and bill prices are rising, then both short term and long –term interest rates are falling. The UK interest rate currently at 0.5% is set by the Monetary Policy committee. The main objectives of the committee involve financial and monetary stability. The adjusting of the base rate is of importance as it affects various functions of the economy. The Bank of England sets the base rate at a level that controls inflation in the short run. The diagram below illustrates how the interest rate works within the United Kingdom. www.bankofengland.co.uk The...
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