Topic 2 Flashcards
Yield Curves
The yield curve shows several yields or interest rates across different contract maturity lengths.
Positive Yield Curves
Expectations of strong economic growth with high inflation and interest rates. The longer the contract, the more inflation is expected to occur, so nominal interest rates must increase so that the real interest rate stays the same.
Positive Yield curves are most common in the real world due to increased risk associated with longer term bonds.
Negative Yield Curves
Occurs when inflationary expectations are low with bleak economic outlook in terms of growth and other investment options. People expect the economy to go into recession and there being deflation, so over longer contracts the nominal interest rate must decrease so that the real interest rate stays the same.
This is rare, however a negative yield curve for the US treasury bond market has preceded all but one of US recessions over the last 70 years.
Estimating Yield Curves
Dont know how to do this.
Money functions
- A Medium of Exchange
- A Measure of Value or Unit of Account or Means of Valuation
- Store of Value
- Standard of Deferred Payment
What determines the nominal interest rate
Equilibrium of MS and MD
Why does MD (Money demand) slop downwards.
Because the nominal interest rate represents the opportunity cost of holding money. At higher interest rates you gain more return for holding your money, so don’t demand as much.
Why is MS (Money supply) vertical.
Vertical as it is controlled by the Reserve Bank and independent of the interest rate.
What influences Money demand?
Money demand is influenced by interest rates, income and inflation, as well as uncertainty about the future. Three motives explain how these effect money demand:
Transactions motive: Most transactions involve an exchange of money. So, when income or GDP rises, the transactions demand for money also increases.
Precautionary motive: People hold money as a precaution against uncertain future events that require immediate payment, e.g. crashing your car.
Speculative motive: The risk to holding money arises from the fact that its value may depreciate due to inflation. This motive comes from how people decide between the risk of holding money compared to the alternative risks of lending or investing it.
Monetary Policy
Different countries have different approaches to how they regulate the supply and demand of money so that their currency remains stable. These include:
Open Market Operations: Buying and selling of securities to increase/decrease funds in the market.
Reserve Requirement Ratio: banks are required to have a certain portion of their cash as deposits. Decreasing this ratio increases the availability of loans, and therefore increases money supply. If this is being used and an amount of money is injected into the economy, the money multiplier = 1/ORR, (ORR: Official Reserve Ratio). This type of banking is called Fractional Banking.
Discount Rate: the central bank lends money to private banks. The OCR is an example of this. This type of banking is called Central Banking.
OCR
Official Cash rate. Every day, private banks are transferring money to one another many, many times. So that the bank has the money available to do so, they keep settlement accounts (deposits) at the Reserve Bank, which earn daily interest. But if the bank doesn’t have enough money in their settlement account to make the transfer, they can borrow from the Reserve Bank. The interest rate that the Reserve Bank gives to settlement accounts and charges for borrowings is called the Official Cash Rate (OCR).
How does a decreased OCR affect customers
Banks will also decrease OCR as they will increase their borrowings from the Reserve bank and decrease their settlement accounts.
Expansionary monetary policy
Involves the RBA Decreasing the OCR.
Supply curve shifts to the right.
This lowers the relative cost of money.
Households increase demand for money to be used for consumption & investment having an upward pressure on prices.
This eventually increases the inflation rate.
Contractionary monetary policy
Involves Increasing the OCR.
Supply curve shifts to the left.
This increases the relative cost of money.
Households decrease demand for money to be used for consumption & investment having an downward pressure on prices.
This eventually decreases the inflation rate.
Reserve Bank of NZ
Operates under the Policy Targets Agreement, a goal of maintaining low stable inflation between the target band of 1-3% to promote investment and economic growth. Unlike other countries whose central banks often focus on growth as well, the Reserve Bank’s sole focus is inflation.
