Interest Rates Flashcards
What are interest rates?
The cost of borrowing money expressed as a percentage of the amount borrowed. Also the rate of return on a financial asset or instrument.
What do interest rates represent in financial markets?
The price that brings equilibrium in the market, the quantity of funds supplied by lenders is equal to the demand from borrowers.
Describe why a supply and demand curve is not a completely accurate model for financial markets.
Financial markets do not operate the same as product or factor markets. The supply of funds is generally unresponsive to changes in the interest rate (inelastic), interest rates are determined by the RBA.
What is a bank’s borrowing rate?
Banks act as borrowers when they accept savings deposits. The borrowing rate is the rate savers earn on their deposit.
What is a bank’s lending rate?
The rate charged on loans from a bank.
How do financial institutions make profit?
By charging a lending rate that exceeds their borrowing rate. This is called the interest rate differential.
What is a short-term interest rate?
The rate on securities with short maturity periods, such as Treasury notes. Generally have a period of less than a year.
What is a long term interest rate?
The rate on a security with a long maturity period (several year) Eg, mortgages can have 25 year loans.
Why do long-term securities have higher interest rates than short-term securities?
Longer-term securities are seen as riskier, as much more can change over time. They are also less liquid, and as a result, lenders will charge a higher rate to cover risk.
What factors influence interest rates?
Demand for capital goods, level of savings, demand for liquid funds, inflationary expectations, government budget, international interest rates, RBA.
How does the demand for capital goods influence interest rates?
Stronger investment demand will lead to higher demand for borrowing from firms. This puts upward pressure on interest rates.
What can lead to an increase in demand for capital goods?
Increase in real wage rate (capital now cheaper than labour) or increased economic activity (capital to facilitate expansion)
How does the level of savings influence interest rates?
A higher level of savings means there is an increased supply of loanable funds, which puts downward pressure on interest rates.
How do inflationary expectations influence interest rates?
Inflation reduces the value of money. If inflation is expected to rise, lenders would require a higher rate to be paid as compensation, increasing interest rates.
How does the demand fo liquid funds influence interest rates?
If individuals have demand for liquid funds, they may hold their money in deposits with banks or as currency, This means the supply of loanable funds decreases, putting upward pressure on interest rates.
