The money market covers all lending for periods less than one year. What is the impact of the policy rate on the broader money market? The central bank will target a very short term rate, usually an overnight lending rate. However, much of the lending in the money market will be for terms longer than overnight. In this segment, we develop the expectation theory of the term structure, to think about the connection between the monetary policy rate and longer term interest rates. Longer term interest rates can be decomposed in an average of interest earned in the short term and forward rates. The interest is implicitly earned in future periods. Forward rates should be equal to the expectations of the future interest rate. After reviewing this segment, you should be able to calculate the effect of policy rates on longer term money market rates. Now let's get started. Interest rate targets are usually set for the overnight market or sometimes one week lending rate. However, inter-bank markets include lending over horizons of up to one year. It is useful to understand how monetary policy rates relate to those longer term interest rates, since much economic activity will be financed with slightly longer term lending. Consider this example, from the fall of 2010 to the fall 2011, when the Bank of Thailand began a cycle of raising the policy interest rate every six weeks, with the exception of one policy meeting early in 2011. As we have seen, overnight rates increase exactly with a policy rate. Longer term interest rates for loans of one and two months in the inter-bank market rose in tandem. But interestingly, the longer term interest rates anticipate the subsequent policy movements in the early part of 2011 with increases in longer term rates preceding the increase in the short term rate. This is because participants in the money market are forward looking. The expectation theory of the term structure is used to explain interest rates over different maturity terms. Under the expectations theory, interest rates on money market lending are the average of monetary policy rates over the life of the loan. The logic is that lenders would not lend at rates lower than the total they could earn by lending you stay in the overnight market, and competitive forces would keep lenders from demanding higher interest rates in the cost of financing in the short term market. To be more specific, the interest rate on lending for N days should be equal to the average of the policy rate in the next N days. For example, on June 30, 2011, the policy rate in Thailand was three percent. The overnight rate was on target at three percent. According to expectation theory, the one-week rate should be equal to the average of the policy rate today and the following six days. Given that the next meeting of the Monetary Policy Committee was not scheduled until two weeks later on July 13th, it would be reasonable to think that the policy rate would be in place over the next week. Therefore, the market might expect the policy overnight interest rate to remain at three percent for each of the next seven days. Averaging a constant of three percent would be three percent, and indeed, the seven-day one-week interest rate with three percent. But as the next meeting date draw nearer, the one-week rate began to separate from the overnight rate. The overnight rate stayed on target, but the one-week rate began to increase in anticipation of a policy change. We chose this example as it was a time period in which the Bank of Thailand was communicating that they would raise rates at the next meeting, making the next interest rate change expected. As expected, the interest rate went up to 3.25 percent and the two series we converged. For example, on the morning of July 12th, you could lend overnight at three percent. The next morning, the one-day rate would also be three percent. But that afternoon, the policy committee should raise interest rate to 3.25 percent, for at least the next six weeks. If the expectation theory were true, the one-week rate would be the average for these overnight rates. This equals 3.17857 percent, compared to a measured interest rate of 3.18 percent. The theory was proved very accurate. Under the expectation theory, money market rates are the average of policy interest rates over the life of the loan. As the loan period covers an upcoming policy meeting, then the longer term rate should be a prorated average of the policy rates before the meeting and the policy rates after the meeting. If the meeting is on day K after the loan is made, they should be equal to a weighted average of the current policy rate and the expected future policy rate. Now that we have seen the prediction of the model, let's take a closer look at the seven-day interest rate leading up to the Bank of Thailand meeting on July 13, 2011. Take a closer look at the one-week interest rate leading up to the July 13, 2011 meeting in Thailand. For a seven day alone, N equals 7. The original policy rate is three percent, and the expected post-meeting rate was 3.25 percent. More than one week before the meeting, the seven-day rate was about three percent as predicted by the theory. But on Friday, next week's meeting becomes relevant, because it appear it will cover one day of lending at the post meeting rate. Expectations theory says that the one-week rate should initially be 3.04 percent cost to actual experience. When the market reopens the next Monday two days later, there will be K equal three days before new interest rates are implemented. Expectations theory suggested interest rates would jump at 3.14 percent. In actuality, they only increase to 3.1 percent. As the week goes along and we get closer to the meeting, the post-meeting rates get more and more weight. Both the expectations theory prediction and the actual one-week rate get closer and closer to 3.25. Finally, all rates go to 3.25 percent after the meeting. Not all rate changes are expected. Consider the most recent rate cut in Thailand on March 11, 2015. The market participants knew a meeting would occur, they did not expect the interest rate to be cut. Thus, a seven-day interest rate did not adjust in the days prior to the meeting. Experience tells us inter-bank rates reflect the future path of monetary policy. The next part of this segment, we'll study how the dynamics of a clear monetary policy stands, impacts inter-bank rates over a longer horizon.