Unit 6 The financial sector: Debt, money, and financial markets
6.11 Household investments: Housing and financial assets
While most people in the economy have at least some interaction with banks—notably in their day-to-day use of bank money as a means of exchange—Figure 6.6 shows that relatively few participate directly in financial markets by trading bonds and shares. But it also shows that a larger proportion of the population interacts indirectly with financial markets via pension funds, which can take advantage of the high potential returns on some financial assets while spreading the risk by investing in a broad portfolio—similarly to the way that banks diversify risk by lending to multiple borrowers.
However, Figure 6.6 showed that in most countries, only a relatively small proportion of households benefit from the real returns that companies earn for their shareholders. We shall see that investing in stock markets can provide high rates of return in the longer term, but they are also particularly risky. To benefit from the high returns on equity, households must be wealthy enough that they can bear the risk.
For many households, their most important material asset is their house. Benefiting from the services provided by the house immediately while paying for it over 30 or 40 years through a mortgage implies they have a long-lasting engagement with the financial sector. Data presented later in this section shows that the rate of return on housing is typically higher than the mortgage interest rate, so households that borrow to invest in housing also benefit from leverage, in the same way that companies do (as shown in the previous section), although with an associated increase in risk (discussed in more detail in Unit 8).
In contrast, it is harder, and often impossible, to borrow from a bank for an education loan because, should you fail to meet the repayments, the bank cannot enslave you and force you to work off the debt. Section 9.9 of the microeconomics volume explains the role of collateral in alleviating credit constraints, and Figure 6.16 shows data on residential debt and equity of households from the lowest to highest quartile.
- collateral
- An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.
With a sufficiently developed financial sector, mortgage financing allows relatively poor households to buy an entire house. The reason that loans are available for housing—even to households with little wealth—is that the house provides collateral for the loan. This means that if the homeowner falls behind on mortgage payments, the bank can repossess the house and sell it. Nevertheless, those with more wealth have a decided advantage for two reasons: some wealth is needed as a deposit, and the greater the deposit, the more favourable the terms of the loan.
The contrasting stories at the start of this unit, of Sophia in the US and Kwame in Ghana, highlight some of the consequences of differences in access to financial institutions. In low-income economies where households have limited or no access to financial institutions or markets, families find other ways to smooth consumption; but almost the only options are to rely on their children to support them in retirement, or to invest directly in physical capital—whether this involves the purchase of a cow (a form of capital), or housing. Since few households can afford to buy a house outright, a common form of investment is just to buy a few bricks when times are good, taking multiple years to build a house (like Kwame does). As a result, unfinished houses such as the one pictured in Section 6.1 are an extremely common sight in poorer countries throughout the world.
Inequality in ownership of assets and liabilities among households in the US
Households hold their wealth mainly in the form of financial assets and housing. Indirectly, through their ownership of financial assets, they own firms and hence the productive assets in the economy (capital, land, and buildings). But ownership of assets—both direct and indirect—is extremely unequally distributed.
- quartiles, quartile groups
- Quartiles split a set of observations into four equally-sized groups. The full set of observations is ordered according to a particular variable (e.g. wealth). The first quartile group is the observations in the bottom 25% (e.g. the 25% with the lowest wealth), the second is the next lowest 25%, and the fourth or top quartile group is the highest 25%. The quartiles are the cutoff values that separate the groups; the first quartile is the cutoff between the first and second quartile groups, and so on.
Think of the households in the US ranked from those with least net worth to those with the most. Some households will have negative net worth because what they owe is greater than what they own (for example, if the sum of their debts—credit card debt, student loan, car loan, and mortgage loan—exceeds the value of all of their assets). The ranked households are then divided into four equally sized groups called quartile groups. Therefore, the bottom quartile group contains the 25% of households with the lowest net worth. Figure 6.16 compares the assets and liabilities of households in the four quartile groups.
Considering debt first, in the ‘All debt’ row the bottom blue bar shows that the top quartile (the 25% of households who have the highest net worth) accounts for almost half of total debt. In general, richer households can borrow more than poorer ones: poor households are more likely to be credit-constrained or excluded from borrowing altogether because they do not have wealth to provide collateral for a loan, for example. Those who can borrow more are able to acquire more assets and, by taking advantage of leverage, access higher returns—which magnifies the differences between rich and poor.
As the blue bar in the ‘All assets’ category shows, the 25% of households with the highest net wealth own more than 80% of total assets, and only a tiny proportion is held by those in the poorest quartile (purple).
Figure 6.16 Comparing assets and liabilities of US households, according to household net worth.
Notes: Proportion of total debts and assets in the economy held by each quartile of the population in 2019. When households are ranked by net worth (assets – debts), the poorest quartile is the 25% of households who hold the least total net worth in the economy.
Source: Federal Reserve System. 2021. [Survey of Consumer Finances.]
The figure also illustrates big differences in the types of debts and assets held. Some people in all four groups own cars and houses. But the two poorer quartile groups hold only a tiny proportion of the financial assets (the bottom four categories in the Assets graph)—and more than 95% are owned by the richest quartile group. It is striking that the poorest 25% has well over 50% of all student loan debt, and the richest quartile has less than 10%.
Household investment decisions and returns
For those who do have wealth to invest, what can we say about the nature of the returns they earn on different assets and, hence, how well different assets play the role of a store of value? To compare rates of return on the various assets a household could hold, we start with currency. Figure 6.17a illustrates that in the US, the real rate of return on dollar bills has been negative in most years since 1900, because inflation has been positive (although relatively low). This is the case in almost all countries—holding currency is a very poor way to save over the longer term.
Figure 6.17a Rate of return on currency in the US (1900–2020).
Figure 6.17b compares the rates of return on three other assets: assets paying the policy rate, equities, and housing. When we consider the impact of the policy rate, \(i\), on the real economy, we argued in Unit 5 that we should look at the real policy rate, defined in terms of the expected inflation rate, \(r = i - \pi^E\). But in Extension 6.9, we showed that the rate of return on any asset paying the policy rate is given by \(i - \pi\), and hence is determined by the actual rather than expected inflation rate.
Figure 6.17b Real rates of return on three other assets, United States.
The real rate of return on assets paying the policy rate
Real rates of return on equities
Real rates of return on housing
Figure 6.17b reports that the returns on both housing and equities have been higher than assets paying the policy rate on average: around 7% and 9% respectively, compared to 1%.
For example, in August 2024 Bank of England data shows that the average interest rate paid on UK current accounts was only 0.7%, at a time when the policy rate was 5%. In 2010, a survey showed that 55% of UK current accounts paid no interest at all.
In practice, very few households would actually have been able to earn even this modest real rate of return on assets paying the policy rate. The closest most households would get would be by investing in saving deposits, which typically pay at least some interest. But deposit rates are typically less than the policy rate, since otherwise banks would not make profits from taking deposits. Interest rates on current accounts are even lower (indeed are often zero) since there are significant costs of providing means of exchange services. As a result, for the typical household with savings in the form of bank money, the rate of return they earned was probably closer to the real return on currency (Figure 6.17a) than to the real return from assets paying the policy rate, which would typically only have been earned by very rich individual investors, or other financial institutions.
But housing and equity returns are also much more volatile. This means holding them for short periods is risky. But a long-term investor—saving over their working life for retirement, for example—can benefit from the high average returns they bring.
Most people who want to own their own home do not explicitly calculate the expected rate of return and compare it to returns on other assets. Since they need somewhere to live, they compare the benefits and costs of owning vs renting, including the deposit required, monthly mortgage payments vs rent, and the security of tenure that home ownership can provide.
But housing is an asset, and from Figure 6.16 for the US, it is the asset, apart from cars, in which ownership is least unequally distributed. We can explain what is meant by the rate of return on housing investment using the same method we use for other assets.
Understanding the rate of return on housing
As explained in Section 6.9, it is possible to decompose the rate of return on any asset into two parts: the capital gain (or change in its price) and the income you receive while holding the asset.
One complication is that if the owner has spent money improving the house, the cost of these improvements would need to be deducted. This is one of a number of factors that make measuring the return on housing more difficult, and more prone to error, than measuring returns on financial assets.
In the case of housing, the capital gain component is relatively straightforward: it is the percentage change in the value of the house.
- imputed rent
- The rent that the owner of a house could receive from renting it to a tenant, rather than living in it.
This is referred to as imputed rent, and in most economies it constitutes a very large component of measured GDP (as discussed in Section 3.3). This is also the way the return on housing in Figure 6.17b is calculated.
What about the income component of the return? For a landlord who owns a house and rents it out, then the income is the rental income they receive, net of any costs associated with maintaining the property. In contrast, if you own a house and live in it yourself, you don’t receive any cash payments. But you do benefit from owning it—you can live in the house. You can evaluate this benefit using the concept of opportunity cost: if you didn’t own the house, you could obtain the benefit of living in it by renting it, or a similar one. So the ‘income’ is the market rent you would have to pay.
The real rates of return on housing in the US, as shown in Figure 6.17b, are measured in this way. The figure illustrates that they have been strongly positive on average. But housing is a risky asset, at least in the short term, because market prices can vary substantially from year to year. If you were to buy a house and sell it a year later, your capital gain could easily be negative.
However, not many people sell a house after just one year, and if you own a house over a number of years, fluctuations in the annual rate of return may not matter to you; what matters is the rate of return over the whole period. Working out the capital gain over several years is straightforward: it is the change in the market price (in real terms) over the whole period.
Whether the rate of return on housing is dominated by the capital gain or the income varies between countries. In the US and Germany, the rental income accounts for most of the substantial average rate of return over the last half-century; real house prices have grown relatively slowly. In the UK, a shortage of housing has led to sustained capital appreciation, but there has been a relatively smaller contribution from rent. The overall impact has been a somewhat higher, but also more volatile, real return. Real house prices have been distinctly more volatile, while rents are relatively stable: in periods of rapidly rising prices, the rate of capital gain has been much higher than the rental income, while in periods of falling prices large capital losses have led to negative overall rates of return.
Exercise 6.11 Debt and equity by income quartile
Figure 6.16 shows how household debt and ownership of assets in the US varies by quartile.
- Find similar data on total debt and asset ownership for your own country (or a country of your choice) and make appropriate charts to show this information. (If you cannot find the data you need, use Table 2 from the UK’s Office for National Statistics Household Debt Inequalities web page to complete this question.) How does the data you found compare with that of the US?
- Use the information in this section and in Section 9.9 of the microeconomics volume to explain the inequalities in debt and asset ownership shown in Figure 6.16. (For example, why is asset ownership so concentrated among the top quartile?)
Comparing assets across 16 countries: Risk is rewarded
Comparing the volatility of the rates of return on the three assets in Figure 6.17, we can see that over the last century in the US the riskiest asset was equities, followed by housing and then bank deposits. But the riskier assets had higher average real rates of return: in other words, investors were rewarded for bearing risk with a risk premium. The extension to this section explains the reasons why some assets are more risky than others, analysing the returns on these three assets and also bonds—and showing, in particular a short-term government bond is a risk-free asset, at least in nominal terms.
Figure 6.18 compares rates of return to investing in short-term bonds, equity, and housing, on average over long periods of time in 16 countries. It shows the average of the annual rates of return over the period, and their volatility—that is, a measure of how much the annual rates of return vary from year to year—to indicate how risky they are. Volatility is highest for equities, followed by housing and then short-term bonds.
| Short-term bonds | Equities | Housing | |
| Average real rate of return | 0.9 | 8.3 | 7.4 |
| Volatility | 3.4 | 24.2 | 8.9 |
Figure 6.18 Global real rates of return: bonds, equities, and housing in 16 countries (1950–2015).
Jorda et al. 2019. ‘The Rate of Return on Everything’, Quarterly Journal of Economics, 134 (3): pp. 1225–1298.
Note: Unweighted averages for 16 countries. Volatility is measured as the standard deviation of returns.
Again, the table suggests that there is a substantial reward for bearing risk. The assets with higher volatility also have higher average rates of return.
To summarize, the trade-off between returns and risk helps to explain the extreme differences in the patterns of wealth-holding between richer and poorer households. Those with more initial wealth can afford to take more risks when they invest it, because they can survive if a bad outcome occurs. So they can choose assets with higher average rates of return, increasing their wealth on average. Furthermore, they can benefit from leverage: they have greater access to credit markets than poor households, so they borrow at low rates of interest to invest in assets with high returns.
Housing is at least a partial exception. Those with modest initial wealth (but enough for the deposit) can borrow to invest in housing because the house itself provides collateral. So a household that is able to buy a house is able to benefit from the reward to risky assets, and leverage—the data shows that real returns on housing are high. Nevertheless, the gains from holding risky assets are skewed towards the relatively wealthier members of society. Furthermore, as Figure 6.6 showed, in lower income economies with less developed financial sectors, the ability to borrow even to buy a house is more limited. And in the poorest economies, where borrowing is typically not possible at all, the only way to invest in houses is, as the example of Kwame showed in Section 6.1, ‘brick by brick’.
Extension 6.11 Rates of return, risk, and bond prices
In the first part of this extension, we compare four types of assets—assets paying the policy rate, equities, housing, and bonds—and examine in particular why some are more risky than others. In the second part, we explain how longer-term bond prices are determined.
From Figure 6.17, we know that the annual real rates of return on some assets—particularly equities—have been much more volatile than on others. Equities are therefore risky for the investor, whereas bank deposits and short-term government bonds are relatively safe, at least in the short term. To understand why, we can apply the decomposition of the rate of return, derived in Extension 6.9:
\[\text{rate of return} (\%) = \text{capital gain or loss} (\%) + \text{income} (\%)\]Specifically, we consider the annual rate of return, consisting of the change in the value of the asset and the income received over the next year. Remember also that it is the real return that matters to investors; that is, the return after adjusting for changes in the general price level.
What makes an asset risk-free?
Our decomposition of the rate of return provides a simple way of defining a risk-free asset: there must be no risk of capital gain or loss, and the income earned on the asset in a year’s time must be known in advance.
This immediately rules out any asset that you will need to sell in a year’s time in order to realise your return, since you will not be able to predict the market price of the asset in a year’s time. So, for example, shares and housing are not risk-free assets.
Typically, economists would argue that two types of investment—short-term government bonds and bank deposits—are risk-free investments, at least in nominal terms.
Short-term government bonds and the policy rate
Economists and professional investors usually treat short-term government bonds as providing the key risk-free asset in the economy. It is fairly straightforward to show that the risk-free rate of return paid by such bonds will also be close to, or equal to, the policy rate, \(i\).
To simplify our analysis, we assume that the bond is a promise by the government to pay one unit of currency in a year’s time, with no other payments either before or after that date. It sells these bonds today at a price, \(p_1\), set by markets; but this price will in turn ultimately be determined by the policy rate, \(i\), set by the central bank.
The ‘1’ indicates the one-year maturity of the bond—later on we shall also consider the case of bonds with longer maturity. Economists actually use a bond that will make a payment in less than a year—typically three months—as the benchmark risk-free asset.
If we return to our general formula for the nominal rate of return, \(1+ \text{RoR}_\text{n} = \frac{\text{what you get back}}{\text{what you put in}}\), then it follows that the return on such a bond will be risk-free if both the top and bottom of the ratio are known in advance.
If the borrower is a government borrowing in its own currency, a promise to pay back a fixed amount in that same currency is completely credible since, as discussed in Section 6.7, currency is a form of government debt, so it is in effect a promise to repay its debt using more of its own debt. If you invest in the bond, what you get back is one unit of currency, and that is entirely free of risk.
What about the bottom of the ratio? ‘What you put in’ is just the price of the one-year bond today, \(p_1\), which you know at the time you buy the bond. Therefore, the rate of return on the bond is:
\[1+ \text{RoR}_\text{n} = \frac{\text{what you get back}}{\text{what you put in}} = \frac{1}{p_1}\]Since the top and bottom are both known, the rate of return must be risk-free. But the formula also tells us that, for this return to be positive, the price of the asset today, \(p_0\), must be less than 1. As a result, these short-term government bonds (also often known in the UK and the US as ‘Treasury bills’) are typically referred to as trading ‘at a discount’, and the rate of return implied by the price is often referred to in the markets as the ‘discount rate’.
For longer-term bonds, the formula is more complicated—we discuss this further later on in this extension.
Another common term used to discuss bond markets is the ‘bond yield’. For one-year bonds, this is equal to the risk-free nominal rate of return implied by the market price, \(p_0\), as given in the formula.
What will determine this rate of return, and hence the price of the bond? The answer is fairly straightforward. In Section 6.7, we argued that reserves held by commercial banks with the central bank are also a component of government debt. In recent years, as discussed in Extension 6.7, the rate paid on commercial bank reserves is simply the policy rate, \(i\). If banks, which are active participants in financial markets, can earn the policy rate on one form of government debt, they will not be prepared to hold short-term government bonds unless they pay the same rate, implying that:
\[1 + \text{RoR}_\text{n} = \frac{1}{p_1} = 1 + i\]or equivalently:
\[p_1 = \frac{1}{1+i}\]For example, if the policy interest rate is 2%, the price of the one-year bond will be \(\frac{1}{1+i} = \frac{1}{1.02} = 0.9804 \approx 1 - i\).
You may recognize this as the present value formula from Unit 5: the price of 0.9804 is the present value of one unit of currency received in one year’s time.
Figure E6.2 shows that this relationship is not just theoretical: for the UK policy rate, it matches the data very closely.
When the series do differ, this is typically due to market expectations that the policy rate would change in the intervening months before the bonds matured—for example, the dip in bond yields in the last few observations reflected expectations that the policy rate would soon fall.
Figure E6.2 The UK policy rate and implied interest rates (‘yields’) on short-term government bonds (maturing in 1 to 6 months).
Bank deposits (savings accounts)
For households—as opposed to professional investors—we think of deposits at commercial banks as a safe way of saving. Commercial banks offer savings accounts that are also risk-free in nominal (currency) terms. There is no risk of capital gain or loss on your investment, so one key source of risk in our decomposition is removed. And savings accounts usually pay a guaranteed rate of interest over the next year, so the income component is also known in advance. Therefore, the overall rate of return is risk-free, and is equal to the interest rate. This lack of risk is typically underpinned by a deposit insurance scheme, which ensures that capital and interest will be repaid (up to a specified amount), even if the bank gets into difficulties.
The reason that commercial banks can provide risk-free assets is that ultimately the promises made by banks to their depositors are underwritten by governments.
But banks also have costs—especially on current accounts that provide means of exchange services—and seek to make profits. So the interest rates they pay on deposits are typically less than the policy rate. Historically, the gap between the policy rate and deposit rates was often substantial. But with the growth of the internet, competition between banks offering online accounts has narrowed this margin substantially, so that interest rates on online savings accounts can sometimes be as little as a fraction of a percentage point less than the policy rate, or equivalently the risk-free return on short-term bonds.
What about the real rate of return? The Fisher equation tells us that the real rate of interest is equal to the nominal rate minus expected inflation. So, for any given rate of expected inflation, you know the real interest rate when you deposit your savings. It is only the possibility of unexpected changes in inflation that make bank deposits risky, as the first slide of Figure 6.17b showed. The extent to which households can regard bank deposits as a risk-free asset depends on the success of the economy’s inflation-targeting monetary policy regime.
Equities (shares)
Equities are typically the riskiest type of financial asset. When you buy a share in a business, it may generate income in the form of profits paid out to shareholders as a dividend. But there is no guaranteed income: the firm may or may not be profitable over the next year and, even if it is, dividends will not necessarily be paid. The capital gain or loss over the year is the change in the share price; whether it rises or falls depends not only on whether the business proves to be profitable this year, but also on the expectations of other investors about its future profitability. These can change rapidly as investors receive new information about the prospects for future success or failure.
Investors will therefore buy equities only if the expected rate of return—what they expect to get back relative to the current price—is high enough to compensate them for the risk. Effectively, they need to be paid (in the return) a substantial risk premium. In terms of the present value model that we introduced in Unit 5, this means that the current share price (what you put in) must be low relative to what you get back in terms of expected future dividends and capital gains.
Housing
The decomposition of the rate of return on housing was examined in the main part of this section. In summary, whether the capital gain component constitutes an important part of the average annual real return depends on the housing market, so differs between countries. But whether or not capital gains can be expected in the longer term, housing is a relatively risky asset, because housing prices—and therefore the annual percentage capital gain—can be highly volatile. The income component, consisting of imputed rent, can also be affected by changes in the housing market, although it tends to be less volatile than the capital component.
Bonds
A short-term government bond is the benchmark risk-free asset. But, as explained in more detail in the next subsection, most government and corporate bonds are promises to make a sequence of payments over multiple years. For an investor with a one-year horizon, a longer-term bond is therefore a risky asset, because they will need to sell the bond to realise their return. Like equity prices, bond prices are determined in financial markets, so the capital gain or loss component in returns on longer-term bonds makes them risky. However, while dividends on a share may be highly uncertain, a key difference for bonds is that the flow of future income is specified in advance, as is repayment of the initial amount at maturity. This means that long-term government bonds are typically viewed as less risky than equities. But they are still far from being risk-free. As we show in the next subsection, prices of longer-term bonds may change significantly before the bond matures, if the policy rate changes in the meantime.
A corporate bond—whether short-term or longer-term—has an added element of risk. While a corporate bond makes promises of future payments, these promises can never be as reliable as promises made by governments, since there is always a risk that the company may go into liquidation and default on all or part of its debts.
Exercise E6.2 Government borrowing
Use two or three paragraphs to explain in your own words the following statement from the text. In your answer, refer to the relationship between the government and the central bank, and use these terms: government bonds, coupon, collateral, high-powered money, credibility.
‘If the borrower is a government borrowing in its own currency, a promise to pay back a fixed amount in that same currency is completely credible since, as discussed in Section 6.7, currency is a form of government debt, so it is in effect a promise to repay its debt using more of its own debt. If you invest in the bond, what you get back is one unit of currency, and that is entirely free of risk.’
Exercise E6.3 Risk and return
- Research the nominal rates of return over one year on the following risk-free assets in your country (or a country with available data): current accounts, deposit (savings) accounts, one-year (or shorter-term) government bonds. Explain why these nominal returns may be different.
- It is more difficult to find data on rates of return on risky assets. However, you should be able to find data on capital gains (or losses) over one year on some of the following risky assets: shares (such as the composite stock index for your country), houses (find a house price index), oil, gold, or cryptocurrency. Comment on the limitations of the data you have been able to find in terms of your ability to measure the true return.
Short-term vs long-term bonds and the impact of interest rate changes
When the US government first issues bonds that will mature in say, 30 years, to fund its borrowing, it sells them for whatever price the market puts on them. The same applies to a company issuing bonds. What will determine the market price of a long-term bond? The answer uses the same principles we have set out for the one-year bond.
When considering whether to buy or sell a long-term bond at a given price, investors know that they could simply hold a sequence of short-term government bonds or hold bank deposits that pay the policy rate instead. So they will need to compare the average expected policy rate over the next 30 years with the equivalent return they will get from holding the bond until it matures.
The general formula for the yield on a bond is quite complicated. But as a relatively simple example, consider the case of an \(m\)-year bond that will make a single payment of one unit of currency in \(m\) years’ time with current price, \(p_m\). Then the ‘yield’ on the bond, \(y_m\), satisfies the following condition: \((1+y_m)^m = \frac{1}{p_m}\)
This condition implies that the yield is equal to the annualized average rate of return from investing in the bond, compounded over \(m\) years. If (and only if) the bond is held to maturity, this return is risk-free, since both the top and bottom of the ratio are known at the time the investment is made. But for any investor who holds the bond for a shorter period, the return will be risky, since they will need to sell the bond to realise their return, and the price at which they will sell it is unknown.
In this particular case the ‘yield’ on the bond, as defined above, will rise one-for-one with the policy rate.
Bond markets, by determining prices for longer-term bonds, effectively determine the interest rates (relative to the policy rate) for borrowing and lending at the longer horizons over which these bonds will mature. These longer-term interest rates, also often referred to as ‘yields’, can be calculated directly from the price of the bond.
Participants in bond markets need to guess what the policy rate will be over the entire life of the bond, which could be as much as 30 years.
Suppose, for example, the central bank raises the policy rate. The price of a one-year bond immediately falls so that its rate of return rises to the new policy rate. If the policy rate goes up by one percentage point, for example, using the formula above, the one-year bond price will fall by 1%, to ensure that the rate of return on the bond matches the policy rate.
Prices of longer-term bonds will fall too, and if the rise in interest rate is expected to be sustained, the price of a longer-term bond will fall by more than the fall in one-year bond prices—sometimes much more, since investors will need to expect the higher return on the longer-term bond to match the expected higher policy rate for longer.
Suppose, to simplify the argument, that the increase in the policy rate is expected to be sustained over the life of the bond. Then, for example, the price of a 10-year bond will fall by roughly 10%, rather than just 1%. Why? Because the price of the bond will need to be expected to rise by 1% every year until maturity, if its expected return, on an annual basis, is to match the higher policy rate. More generally, if an increase of one percentage point in the policy rate is expected to persist for \(m\) years, the price of a bond with \(m\) years to maturity will fall by \(m\)%. As a result, the longer the maturity of the bond, the more volatile is its price, and hence its short-term return. This is what makes longer-term bonds risky in the short term.
Just how risky longer-term bonds are will depend crucially on the monetary policy regime. The calculated changes above were based on the assumption that a rise in the policy rate will be sustained. But if monetary policy follows the model of an inflation-targeting central bank of Unit 5, markets will usually expect that the policy rate will not be sustained indefinitely, but will revert back to more normal levels in due course. The average expected policy rate, and hence rates for longer-term borrowing, are typically more stable than the policy rate itself.
Why would markets expect this to be the case? As illustrated in Figure 5.7, the central bank reacts to a shock by loosening or tightening monetary policy and, once inflation is back at target, the policy rate will return to its original level (ceteris paribus).
