Topic 4: Interest Rate Determination Flashcards
RBA
Is a central bank of Australia
Responsible for the implementation of the monetary policy
Objectives of the RBA monetary policy
Manage inflation – maintain inflation between 2-3 per cent.
Assure stability of currency
Maintenance of full employment in Australia
Economic prosperity and welfare of the people in Australia
In most developed economies monetary policy actions are directed
at influencing interest rates.
Monetary policy decisions are expressed in terms of
a target for the cash rate, which is the overnight money market interest rate.
If this short-term cash rate changes
there is an expectation that, in an efficient market, medium-to-long term interest rates will change over time to establish a new equilibrium
By understanding what motivates a central bank in its implementation of interest rates policy:
financial market participants can anticipate changes in a government’s interest rate policy
lenders and borrowers can make better-informed decisions
A central bank may increase interest rates if there is:
- inflation above target range
- excessive growth in GDP
- a large deficit in the balance of payments
- rapid growth in credit and debt levels
- Unsustainable and ongoing price increases in major economic sectors, such as property or the mining
- excessive ‘downward’ pressure on FX markets.
Business Cycle
The change in economic activity over time through cycles of expansion and contraction
GDP
The aggregate value of goods and service produced within a domestic economy
Balance of Payments
A record of a country’s transactions with the rest of the world
An increase in interest rates (i.e. tightening of monetary policy) will
eventually increase long-term rates
slow consumer spending
- reducing inflation and demand for imports
decrease the size of the current account deficit
possibly attract foreign investment
- causing the domestic currency to appreciate
Method used by central bank to implement monetary policy
Open market operations
Three main open market operations
Buying and selling of government securities
Repurchase Agreements
Foreign currency swaps
Liquidity effect on interest rates
The effect on the money supply and system liquidity of a central banks open market operations
Income effect on Interest Rates
If the interest rates rise, economic activity will begin to slow and incomes will fall, thus allowing rates to begin to ease
Inflaction effect on interest rates
As an economy slows, the upward pressure on prices will ease, thus allowing interest rate to fall
Economic indicators
provide market participants with insight into possible future economic growth and the likelihood of central bank intervention.
Three categories on Economic Indicators are
Leading Indicators
Coincident Indicators
Lagging Indicators
Leading Indicators
economic variables that change before a change in the business cycle.
e.g., Bonds Yield, if bonds yield curve is positively sloped then economy is expected to be doing well.
Coincident indicators
economic variables that change at the same time as the business cycle changes.
e.g., Personal income; Personal income is a coincidental indicator for the economy: high personal income rates will coincide with a strong economy.
Lagging indicators
economic variables that change after the business cycle has changed.
e.g., Unemployment rate; If the unemployment rate is rising, it indicates that the economy has beendoing poorly.
Asset
is a piece of property that is a store of value.
What determines the quantity demanded of an asset
Wealth
Expected Return
Risk
Liquidity
Wealth
the total resources owned by the individual, including all assets.
Expected Return
the return expected over the next period on one asset relative to alternative assets (e.g., bond return vs. stock return).
Risk
the degree of uncertainty associated with the return on one asset relative to alternative assets (e.g., risk with holding bonds vs. risk with holding stocks).
Liquidity
the ease and spee d with which an asset can be turned into cash relative to alternative assets (e.g., risk with holding bonds vs. risk with holding stocks).
Liquidity Preference Framework
An equilibrium interest rate is determined by supply and demand for money
Define Money
Money is M1 (monetary based): includes cash, travellers’ cheques, and checkable bank’s deposit
Three motives for holding money
Transactions motive
Precautionary motive
Speculative motive
Transactions motive
day-to-day use
Precautionary motive
unforeseen transaction, e.g., medical bill or car accident bill
Speculative motive
left over money for investment on bonds, which earns interest amount
Liquidity Preference Framework Assumptions
1 - only two financial markets: Money market (short-term) and bonds market (long-term)
2 - only two choices to store their wealth: Money (Cash or cheques or bank deposits) and Bonds
3 - The amount of money or bonds held cannot be equal zero
4 - Return on Money = 0 or negligible
5 - Return on Bonds > 0 and = interest rate (𝑖)
6 - Bonds are not risky
7 - Central bank controls the amount of money supplied in the economy
Liquidity Preference Framework Due to assumptions 1 and 2
- There are only two financial markets: Money market (short-term) and bonds market (long-term).
- People in the economy have only two choices to store their wealth: Money (Cash or cheques or bank deposits) and Bonds.
- Total (Financial) wealth in the economy = Money + Bonds.
- In supply-demand language, we can write this as follows:
𝑩𝒔 + 𝑴𝒔=𝑩𝒅 + 𝑴𝒅 −−−−−−−(𝟏)
We can also write EQ (1) as:
𝑩𝒔−𝑩𝒅= 𝑴𝒅 –𝑴𝒔−−−−−−−−−(𝟐)
- If the Money market is in equilibrium (𝑴𝒅=𝑴𝒔), then bond market is also in equilibrium, converse is also true.
Note: Right hand side of EQ (2) forms a basis for liquidity preference theory and Left hand side of EQ (2) forms a basis for loanable fund theory.
Liquidity Preference Framework Due to assumptions 4-6
Assumptions:
4 Return on Money = 0 or negligible
5 Return on Bonds > 0 and = interest rate (𝒊)
6 Bonds are not risky
increase in the 𝑖 will increase the 𝐵d, and consequently will reduce the 𝑀𝑑
- 𝑀𝑑 is inversely related with 𝑖
- If you hold money you will lose interest amount that is otherwise available with holding bonds, this is simply called as Opportunity Cost of holding money
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝒎𝒐𝒏𝒆𝒚
𝑭𝒐𝒓𝒆𝒈𝒐𝒏𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 that is available with holding bonds
Liquidity Preference Framework Due to assumptions 7
Assumption 7
Central bank controls the amount of money supplied in the economy.
The 𝑀𝑆 curve will be a vertical line.
𝑀𝑆 curve is insensitive to changes in 𝑖.
Two factors responsible for shifting the 𝑀𝑑 curve in Keynes liquidity preference framework are:
- Income effect
Increase in income leads to an increase in demand for money. - Price-level effect
Increasing prices lead to a fall in purchasing power which causes increase in money demand.
Factors responsible for shifting the 𝑀𝑠 curve
Central Bank buys Government securities which causes the money supply to increase
Central Bank sells Government securities which causes the money supply to fall
Effects of Money on Interest Rate
Liquidity Effect - expansionary monetary policy means lower interest rate.
Income Effect - expansionary monetary policy means that higher wages and thereby higher income level.
Price and Expected Inflation Effects - expansionary monetary policy means that higher wages and thereby higher income level.
Effect of higher rate of money growth on interest rates is ambiguous
Would depend whether liquidity effect dominates the income and price level effects or the last two effects dominate the liquidity effect.
Real interest rate
Nominal interest rate – Expected Inflation
Factors that shift the Bond Demand Curve
- Wealth
- Expected Return and Expected Inflation
- Risk
- Liquidity
Factors that shift the Bond Demand Curve (Wealth)
Economy grows or savings grows , wealth grows , 𝐵𝑑 grows.
Factors that shift the Bond Demand Curve (Expected Return and Expected Inflation)
- 𝑖 decrease in future, 𝑅𝑒 for long-term bonds increase
- 𝜋^𝑒 decreases, Relative 𝑅𝑒 increases
- Expected return on bonds relative to other assets increases, 𝐵𝑑 increases
Factors that shift the Bond Demand Curve (risk)
- Risk of bonds decrease, 𝐵𝑑 increases
- Risk of other assets increases, 𝐵𝑑 increases
Factors that shift the Bond Demand Curve (Liquidity)
Liquidity of Bonds increases, 𝐵𝑑 increases
Liquidity of other assets decreases, 𝐵𝑑 increases
Loanable Funds
The amount of funds available for lending within the financial system
Perspective of Loan Markets
Provides model of interest rate determination
Supply of Bonds =
Demand for Loanable Funds
Demand for Bonds =
Supply of Loanable Funds
Loan market approach to interest rate determination (The Loanable Funds Approach)
Proposes that the rate of interest is determined by the supply and demand for loanable funds (LF).
LF are the funds available in the financial system for lending
Loanable Funds Theory - As IR Rises
Demand falls and supply increase
Demand for loanable funds has two components
Business demand for funds (B)
- Short-term working capital
- Longer-term capital investment
Government demand for funds (G)
- Finance budget deficits and intra-year liquidity
Supply of loanable funds comprised of three principal sources
Savings of household sector (𝑆) [note: Mishkin also adds Government savings].
Changes in money supply (∆ 𝑀)
Dishoarding (𝐷)
Hoarding
is the proportion of total savings in economy held as currency.
Dishoarding occurs
as interest rates rise as more securities are purchased for the higher yield available.
theory of portfolio choice
tells us how much of an asset people will want to hold in their portfolios
theory of portfolio choice, states that, holding all other factors constant:
quantity demanded of an asset is positively related to
- wealth.
- its expected return relative to alternative assets.
- its liquidity relative to alternative assets.
The quantity demanded of an asset is negatively related to
1. the risk of its returns relative to alternative assets.
Fisher effect,
When expected inflation rises, interest rates will rise.
In Keynes’s liquidity preference analysis, two factors cause the demand curve for money to shift:
income and the price level.
Income Effect
higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right
Price-Level Effect
a rise in the price level causes the demand for money
at each interest rate to increase and the demand curve to shift to the right.
an increase in the money supply engineered by the Federal Reserve will shift
the supply curve for money to the right.
when income is rising during a business cycle expansion (holding other economic variables constant)
interest rates will rise.
when the price level increases, with the supply of money and other economic variables held constant,
interest rates will rise
When the money supply increases (everything else remaining equal),
interest rates will decline
