The Money Market

Question 1

Explain supply and demand in the money market

Answer 1

Borrowers are consumers demanding funds. Lenders are the producers supplying funds.

Question 2

Explain how the price of money is determined in the money market

Answer 2

The price of money in the money market is not determined by equilibrium of market forces alone, with the RBA playing a key role in influencing various interest rates in the economy

Question 3

Why may individuals borrow? (x2)

Answer 3

• For personal reasons, mainly mortgages for purchasing a house
• For large short larger purposes such as purchasing a car or international travel

Question 4

Why may businesses borrow?

Answer 4

To expand production. invest in and research development etc.

Question 5

Why may governments borrow? (x3)

Answer 5

• To stimulate the economy through spending
• If the realised value of the budget is lower than expected
• If they need more money to fund a large infrastructure project

Question 6

Describe the factors affecting the demand for funds (Motives) (x3)

Answer 6

Transactionary motive - funds are needed to pay day to day expenses and conduct transactions

Precautionary motive - Funds that are held in case adverse situations arise i.e. money for a rainy day

Question 7

Why may individuals lend?

Answer 7

They may have a surplus and do not need liquid funds

Question 8

Why may businesses lend?

Answer 8

They have retained profits and are seeking to invest them to make a profit

Question 9

Why may governments lend?

Answer 9

• They are running a surplus

- If the realised value of the budget is higher than expected

Question 10

Why may the international sector borrow?

Answer 10

• They are looking to invest in return for a profit

- Australian interest rates offer an incentive to invest in Australis

Question 11

Name the factors that influence the general level of interest rates (x6)

Answer 11

• The demand for capital goods (investment)
• The level of savings in the economy
• The demand for liquid funds
• Inflationary expectations
• Government budget
• International interest rates
• Domestic market operations

Question 12

How does the demand for capital goods influence the level of interest rates?

Answer 12

Stronger investment demand will lead to higher demand for borrowing by firms seeking to finance their capital expansion, putting upward pressure on interest rates

Question 13

How does the level of savings in the economy affect the level of interest rates?

Answer 13

A higher level of savings means that there is an increased supply of loanable funds, which should put downward pressure on interest rates

Question 14

How does the demand for liquidity affect the level of interest rates?

Answer 14

If there is a preference for liquid funds, then the level of funds available to loan will decrease, leading to lower supply and putting upward pressure on interest rates

Question 15

How do inflationary expectations affect the level of interest rates?

Answer 15

If inflation is expected to rise, lenders would require a higher rate of interest and this would put upward pressure on interest rates

Question 16

How do international interest rates affect the level of interest rates?

Answer 16

If interest rates overseas were lower, this would encourage domestic lenders to invest their money in overseas as they could earn higher returns leading to a reduction in supply, resulting in upward pressure on interest rates

Question 17

What is the overnight money market?

Answer 17

The market where banks have a shortage of funds have a shortage of ES funds can borrow money from banks that have an excess of ES funds beyond what they need in their accounts

Question 18

Explain the policy rate corridor :-)

Answer 18

The RBA first pays an interest rate to banks on funds held in ES accounts that is always 0.25% below the cash rate target. This means that banks with excess ES balances are not incentivised to lend funds to other banks if the actual cash rate is less than 0.25% below the target; these banks can earn greater returns by simply leaving their extra funds in their ES account. The RBA’s deposit rate, therefore, creates a ‘floor’ or minimum value for the cash rate

Second, the RBA is willing to lend ES balances directly to banks outside of the overnight market. The RBA sets an interest rate on these loans equal to 0.25% above the cash rate target. Banks that need to borrow ES balances are not incentivised to pay a rate higher than the RBA’s lending rate, banks would simply borrow ES funds directly from the RBA outside the overnight market. The RBA’s lending rate, therefore, creates a ‘ceiling’ or maximum value for the cash rate

Together, the floor created by the RBA’s deposit rate and the ceiling created by the RBA’s lending rate form the policy rate corridor for the cash rate

Question 19

Why is the policy rate corridor responsible for implementing changes to the RBA’s cash rate target

Answer 19

This is because the ceiling and floor are automatically set so that the cash rate target is in the middle of the corridoor

Question 20

What do banks and the RBA do when TIGHTENING monetary policy? (x3)

Answer 20

• The RBA raises the policy rate corridoor
• Banks pay more to borrow ES funds
• To maintain margins, banks increase interest rates

Question 21

What do banks and the RBA do when LOOSENING monetary policy? (x3)

Answer 21

• The RBA reduces the policy rate corridoor
• Banks receive less interest from loans of ES funds
• To maintain margins, banks decrease interest rates

Question 22

What happens as a result of TIGHTENED monetary policy?

Answer 22

• The cash rate goes up
• Consumers and businesses have to pay more on existing debts; new borrowers find it harder to borrow funds
• Consumption and investment spending decreases
• Economic activity decreases

Question 23

What happens as a result of LOOSENED monetary policy?

Answer 23

• The cash rate goes down
• Consumers and businesses have to pay less on existing debts; new borrowers find it easier to borrow funds
• Consumption and investment spending increases
• Economic activity increases

Question 24

What are domestic market operations?

Answer 24

Actions by the Reserve Bank to manage the supply of funds in the overnight money market. These actions involve the purchase and sale of financial securities