chapter 13: interest rate determination Flashcards
what are some reasons to hold money rather than financial assets
- trnasactions motive: day to day purchases as most financial assets such as shares cannpt be used for everyday purchases
- precautionary motive: unpredictable circumstances and emergencies
- speculative motive: buying financial assets carry possibility of making financial gain or loss ie if ppl think the value will fall then they will seek to sell their shares
why has there been a decrease in demand for liquid funds
individuals and buses can confidently hold more of their savings in less liquid fniancial assets as the enhanced operation of financial markets has meant that people find it easier to convert financial assets –> in short, ease of electronic transactions
what is the main opp cost of holding liquid funds
the main opp cost is the forgone returns (or interest) that would have been earned from holding financial assets. However as long as the benefit of holding liquidity (no risk of capital loss) outwighs the costs (the returns forgone), individuals will seek to hold money rather than financial assets
how can businesses participate in financial markets as lenders
a successful bus with strong cash flow may not have immediate plans for expansion –> deposit in financial institution where is interest lvls are high it may be more lucrative than investing in expanding the bus –> more liekly to deposit
how does the international sector supply funds for domestic borrowers
historically, aus had low savings rates and relied upon overseas savings to finance domestic consumption and investment
what are the four characteristics of money
- medium of exchange - goods, services and resources are exchnage for money
- a measure of value - money can be used to compare the relative value of goods and resources over time
- a store of value - money can be used to measure the value of goods, sevrices and resources over time
- a method of deferred payment - money allows the development of a system of lending and borrowing
define interest rates
the cost of borrowing money expressed as a percentage of the total amount borrowed –> the price that brings about equlibirum in a financial market
what are some other terms for a rate fo interest
a borrowing rate or a lending rate however, the difference b/w these two rates is known as the interest rate differential or net interest margin
distinguish b/w short term and long term interest rates
- interest rates on loans with a maturity of less than a year are known as short term interest rates
- interest rates with long term maturities are knwon as long term interest rates (more risky and less liquid as more can change over time and more difficult to convert them into cash)
- the return req’d for long term securities will usually be higher and lender will receive a higher interest rate
what are some factors that will influence the gnereal level of interest rates
- the demand of capital goods (investment) ie high demand –> high investment/borrowing –> banks will raise interest rate
- the level of savings in the eco ie low savings –> low access money supply for banks –> raise interest to encourage savings
- the demand for liquid funds ie borrowing from banks is more liquid and accessible –> increase demand of money from banks will encourage banks to raise interest rate
- inflationary expectations ie if eco expect inflation they will raise price today hence causing inflation in itself
- international interest rates ie if US had a higher interest rate on savings than aus, RBA would have to increase their interest rate due to a decrease in supply of funds
what is DMO (domestic market operations)
DMO refers to the purchase and sale of second hand government securities (ie Treasury notes and Treasury bonds that have been issued previously) by the RBA, for the purpose of influencing interest rates
how do dmos work
when the supply of funds in the official short term money market increases the cash rate of interest falls, on the other hand, when the supply of funds in the settlement market decreases, the cash rate will rise
the RBA can control this in the overnight money market by purchasing and selling second hand gov securities
what is tightening monetary policy
raising interest rates ie
RBA sells gov securities due to shortage of borrowable funds –> increase cash rate –> consumers & bus have to pay more on existing debts and new borrowers hard to borrow funds –> consumption decreases and eco activity decreases
what is the loosening of mp
lowering interest rates ie
RBA buys gov securities due to excess of borrowable funds –> decrease cash rate –> consumers and bus pay less on existing debts & find easier to borrow funds –> consumption and spending increase –> eco activity increase
what is the overnight money market (aka short term money market or OMO)
the market where banks that have a shortage of ES funds can borrow money from banks that have excess of ES funds. The market allows them to settle their interbank payment obligations
demand of borrwoers and and supply from lenders interact to set the market price (interest rate). eg when supply of fund from lenders increase due to excess ES balances, the price of borrowing this money (cahs rate) will fall
RBA intervenes heavily to ensure actual cash rate lines up with a target (thru policy rate corridor and OMO)
