TOPIC 5 ECO (chapter 12 - 13) Flashcards
financial markets
provide products that provide returns for HH & businesses w/ excess funds & make funds available to those needing additional money for consumption or investment (C&I)
financial intermediaries (banks)
firms hold savings (accumulated funds) of individuals/firms as DEPOSITS, make LOANS to other FIRMS/IND who can make USE of them
bridge between savers & borrowers in economy
4 sources of savings
- proportion of household income not spent on consumer goods
-
business who dont distribute all profits to owners
-funds not distributed can be supplied to financial markets until needed -
GVT budgets for SURPLUS
-revenue > expenditure - FOREIGN pools of savings supplied by individuals, firms & GVTs from overseas AUS can borrow from
4 reasons for borrowing for each person
- consumers borrow when demand for g&s EXCEEDS current capacity to pay
-borrow to purchase houses - entrepreneurs/bus managers borrow to FUND OPERATION/EXPANSION of businesses
- GVT borrows funds when it BUDGETS for DEFECIT
-expenditure > revenue -
AUS financial institutions (banks) LEND money OVERSEAS to borrowers
-AUS NET borrower in GLOBAL financial system, borrows more than lends overseas
financial markets are the ___ markets for ___ in an economy
factor markets for capital
income isn’t expended immediately & still constributes to present aggregate demand by allowing others to borrow surplus for immediate C&I
since when were financial markets more important for the economy?
since the financial sector was deregulated in early 1980s
financial instruments
shares, investment funds, superannuation, bonds
what financial services does AUS fianncial sector provide
home mortgages, credit cards, personal loans, super management, insurance
securities
any form of financial instrument that provides holder of instrument with claim over real assets/future income stream
2 types of financial markets
- primary financial markets
- secondary financial markets
primary financial markets
facilitate CREATION of financial ASSETS (SECURITIES) can sold into economy
-bus wants raise funds, borrow money by issuing debt securities/expand ownership of company by selling new shares
-money received from investors directly to company
secondary financial markets
transactions w/ financial assets ALREADY ISSUED on primary market in PAST
-no NEW financial ASSET is CREATED, but OWNERSHIP of existing financial asset TRANSFERRED from 1 individual/bus to another
-companies whose securites TRADED here DONT receive MONEY from TRANSACTIONS
ASX
australian securities exchange
-PRIMARY and SECONDARY financial market
major share market in AUS, purchase & sale of most shares in PUBLIC companies
-share market brings together ppl wishing to buy & sell shares to allow TRANSACTIONS occur
4 main financial markets across the WORLD
SDDF
SHARE/equity market
ownership shares in companies issued/exchanged
DEBT market
-debt securities (eg. bonds) exchanged/cash lent & borrowed
DERIVATIVES market
-ppl buy & sell financial assets based on VALUE of OTHER financial ASSETS
FOREIGN EXCHANGE market
-financial assets defined in 1 country’s currency exchanged for assets defined in another country’s currency
all financial intermediaries perform the same basic function:
channel excess savings from NET SAVERS in economy to those wishing to borrow frunds (NET BORROWERS)
non-financial intermediaries
legally cannot hold deposity
banks (financial) hold deposits on behalf of savers
banks comprehensive offer of financial services
-accepting deposits (savings)
-making advances (loans)
-issuing credit cards
-arrange overseas payments & collect funds
fintech
type of financial services business using tech eg. AI to increase efficiency/deliver new services
other financial institutions FICPS
Finance companies
investment banks
credit unions
permanent building societies
superannuation funds
finance companies
obtain most their funds by borrowing from general PUBLIC, issuing DEBT SECURITIES/from banks (non-financial businesses)
-funds loaned out to households/businessese at HIGHER rates of INTEREST to make profit
-fintechs
investment banks
borrow on short-term basis from companies with SURPLUS FUNDS
-lend funds to other large companies (expand business) & GVT agencies
-provide financial advisory services to large companies eg. takeovers, trade securities for profit
credit unions
non profit cooperative organisations
-members belong to certain trade, industry, profession, live certain area
-ppl deposit/borrow money with profits returned to members
permanent building societies
accept deposits from PUBLIC & provide FUNDS mainly for HOME LOANS
-also offer business loans but interest rate structure controlled lil by STATE GVTs
superannuation funds
long term contribution of employees & ers and invest in financial assets to provide retirement income for contributors
credit
loans extended to individuals, businesses & GVTs for spending on C&I
-constitutes assets for financial intermediaries that derive income from & liabilities for individuals & bus that borrow funds
consumer credit
allows consumers to purchase consumer g&s in advance of actual payment
-enables individuals to tap into future streams of income likely to receive to fund consumption in present
msot common type of consumer credit & function
credit cards allow consumers to purchase goods & repay borrowings with INTEREST at later date
credit cards are offered by
banks
credit unions
non-financial corps eg. woolies in conjunction with credit card companies eg. mastercard
another major form of consumer credit
personal loans offered by banks & credit unions eg. afterpay
-charged at higher rate of interest > housing loans
-diff in interest rates charged on diff financial products reflect diff in RISK to LENDER borrower wont be able to pay back
why do successful economies depend on a competitive financial system?
transform **savings **–> productive investment –> higher SOL and eco growth
increased comp improves ALLOCATION of resources in eco –> easier for firms to raise funds
are australia’s financial markets successful?
yeah they large and sophisticated
australia’s banking sector is not that/highly concentrated in the developed world
ANZ, Commonwealth, NAB, Westpac dominate markets for deposits, home loans, other lending
large market shares, major banks wield sig market & pricing power, enabling to raise retail deposit rates slower than borrowing rates, :(
why do GVTs face pressure to increase competition in the banking sector?
assume banks make excessive profits, ‘ripping off’ households & small bus w interest rate margins, other fees
how do GVTs try increase competition
policies for easier switching between banks
-ban mortgage exit fees
-impose duty on dinancial advisers to put interests of clients first
housing loans
offered by banks & non-bank financial institutions (building societies)
long term loans to purchase property, requiring periodic repayments with interest
financial futures & options
contracts to trade in financial instruments at later date for certain price
-futures markets allow investors protect themselves against adverse movements in interest rates, currency fluctuations/share prices by agreeing on price & currency to buy/sell financial product in present, dont make transaction until later date
-options give investors’ holder RIGHT to make transaction but NOT OBLIGATION to complete transaction, can NOT let option expire (less risk)
foreign exchange
market for buying & selling foreign currencies
-investors & bus need foreign currencies when doing business with ppl overseas
7 financial market products (to meet needs of lenders & borrowers varying risk, return & liquidity)
CHBSBFF
- consumer credit
- housing loans
- business loans
- short term money markets
- bonds
- financial futures & options
- foreign exchange
BUSINESS LOANS
SMR rates, where they borrow from
form of debt allows bus to invest in operations & expansion
-rates on loans to SMEs > housing loan rates (mortages typically ‘secured’ by property to purchase)
-lenders can sell their property in situations when borrowers default on their debt to offset losses on loan, so loans arent as risky to provide
-greater risks lending to small businesses (most likely to default on their loan obligations)
-small bus typically borrow funds from finance companies & banks
-large companies borrow from investment banks too
short-term money markets
bring bus & ind together with temporary shortages/surpluses of funds
-those with surplus funds (eg. banks) issue various forms of debt securities (eg. bank bills) to those in need of funds
-debt securites have maturity date <1yr
gvt/company borrows money from investors
bonds aka long-term debt security
less risky than stocks
written record of debt
-borrower sells bond in return for LOAN
-holder/lender of bond receives INTEREST(coupon) payments and final(principal, face value of debt) repayment from issuing institution at end of bond period (maturity date)
-rate of financial return/risk on bond (yield) calculated by dividing coupon payment by bond price
-if interest rates ^, yield on bond ^ but coupon paymentws are fixed so its reflected in lower price for bond (price of bond fluctuates according to changes in lvl of interest rates)
-can be sold in SECONDARY financial markets
-issued by GVT and few large companies & banks
superannuation
AUS employers obliged to pay contributions to employees superannuation accounts (early 90s)
-superfunds invest into financial products (shares, bonds) in AUS & overseas
-employees retire, funds available as retirement income (regular payments/single sum)
superannuation roles for AUS economy
-source of retirement income
-system allows more ppl to indirectly own shares & participate in sophisticated parts of finance sector with higher returns, than simply depositing money in savings bank
-growth of super reduces pressure on gvt to provide income for retired aussies
-gradually increasing
large pool of finance created promotes growth in eco
-money in super funds can be loaned to financial institutions to provide loans to housholds (eg. mortgages) & businesses
-also can be directly invested in new share issuances by businesses to purchase more capital
how do changes in superannuation have significant impactso n the rest of the economy?
large amt super invested in shares = changes to share market main driver of superannuation balances
-super industry regulated by GVT through APRA
share
type of financial asset provides individual with ownership over part of business/company
share market
financial market where investors buy & sell shares
only deals with trade in shares of PUBLIC companies
why does the share market play an important role in the AUS eocnomy
businesses can sell shares in their companies to raide funds for growth
individuals/other businesses can gain returns on their og bus’ surplus funds
how can a firm issue shares?
-must be COMPANY, (INCORPORATED!!)
-LIMITED LIABILITY
incorporated business
legal process recognised as separate legal entity from owners/managers of business (no matter what happens to shareholder, business continues operating)
* assets and cash flows of the business entity are kept separate from those of the owners and investors (limited liability)
-easier for a business to sells shares, raise capital
-fails, indivudals who operate business protected from risk of bankruptcy
incorporated businesses can be either ____ or ____
public or privatep
public company shares
no transfer restrictions (beyond those established by GVT regulation)
-company’s shares can be traded freely on share market
private ocmpany
restricts ownership of shares to only few (<50) individuals & places restrictions on share transfers so ownership cannot be freely bought/sold betw individuals
-Pty Ltd propriety limited
how does the ASX provide a regulated environment for investors to buy & sell shares?
matching sellers who have desired selling price with buyers willing to pay that price
investor can buy/sell sahres through BROKER registered with ASX
-broker can be specialist online trading agency/finance company/stockbroker (person)
-online brokerages popular recently cause low cost & accessible way of trading shares
reasons for investors to purchase shares
gain stake in company profits
make capital gains from increases in share prices
owning shares = right to vote for company’s board of directors who appoint company’s senior managers
-decide how company will act to maximise wealth of shareholders
-shareholders meet once a year to vote matters & voice opinion
-mangers have FIDUCIARY (legal) duty to manage company in way serves interests of shareholders
shareholders as owners of company
entitled to share successes of company
-company refutnrs profit, prop returned to shareholders (DIVIDENDS) awareded per share
-most companies autonomy to decide what fraction of profits returned to shareholders
-company grows, value share price increases, shareholders can sell shares for more than paid them (CAPITAL GAINS)
possible gains for shareholders
value of shares increasing, may sell any time to make gain
risks for shareholders
company loses money/closes due to failure, only stand to lose amt initially invested in shares (limited)
-not responsible for further debts of company
dividends
profit returns received by shareholders (owners) of business
capital gains
profits made by investors who sell their shares/assets at price ABOVE level originally paid for them
float
company lists itself on stock exchange & offers its shares to public first time
DEBUT
share market benefits for company
opportunity to raise new funds for investment & growth
-once listed, access further equity funds any time by issuing approved prospectus for release of new shares
-issuing new shares REDUCE CONTROL existing shareholders have over company, (own smaller prop of company)
sale of new shares is a _____ financial market transaction
primary
when EXISTING shareholder sells shares to another investor, what financial market transaction is this? (most trades in australia) primary/secondary
secondary
a company’s share price is SET by the market forces of ___ and ___
supply and demand
what factors does a company’s share price reflect
-confidence in management
-previous & expected earnings
-general eco conditions
if company’s share price loses value for shareholders, what do shareholders do and what happens to the company
put pressure on management to improve performance & even vote new management
threat of possible takeover
relationship between general eco conditions & share values
fluctuations in share market mirror changes in eco growth
-down/upturns in share market measured by ALL ORDINARIES INDEX
-share market much LESS STABLE than real eco (small change in eco growth –> enormour change in share values)
all ordinaries index
stock market index measuring changes in overall value of companies listed on ASX
how do share markets act to allocate resources to diff types of production?
companies & sectors with best growht prospects able to use additional investment funds most effectively
-raise msot funds when floated
-raise medium-term growht prospects of economy
-share prices higher for firms in industries shareholders expect high growht
major problem using share market as guide to health or eco/indicator of industry growth
assume all share purchases based on rational, confident beliefs of shareholders
-share purchases SPECULATIVE, bought with intention of being resold within short period
-investors dont buy to gain long term income stream from shares but hope for short-term capital gains
-speculators base investment decision on ‘HYPE’ in market, not real profitability of firms –> shares/industries may overvalue prices, draw further investment & misallocate resources
speculation
investors buy assets with intention of reselling for higher price in short period
recent decades seen dramatic increase in participation of foreign investors in AUS markets. why? (2)
- both through increased lending to AUS
- increased foreign ownership of AUS companies
AUS financial markets become closely INTEGRATED with global markets last 3 decades. what does this reflect? (3)
falling communications costs
increased reliability & speef of electronic transfer of funds
deregulation of AUS financial markets since 80s encouraged foreign participation in domestic markets
when has AUS been more open to FEM?
1983
why are global debt markets important for AUS eco development?
reliance on foreign borrowing
-AUS net borrower, borrows funds overseas > lends foreigners
what facilitates AUS foreign movement of funds?
AUS 4 major banks source finance for domestic loans from overseas
foreign banks established stronger presence since AUS operations established 1985
equity markets
regulated by NATIONAL GVTs, exist primarily within individual countries
-companies raise capital to startup or expand their enterprises
-meet issuers and buyers of stocks in a market economy.
international movement of funds betw equity markets dominated by financial institutions (banks)
domestic & global markets FGE
foreign exchange markets
global debt markets
equity markets
Australia is primarily a ___ market with foreign participation than ___ market, regulated by the ___
domestic
global
ASIC
2 + 2 international organisations limited functions of regulation in GFM
-
Bank for International Settlements BIS
-international org helps central banks promote financial stability through market regulations
-Basel Committee sets standards for banking regulations to promote uniform financial regulatory systems globally - International Monetary Fund IMF
-general stability of international financial system
-monitors ecos & markets
-provides financial assistance to countries diff meeting IF obligations - International Organisation of Securities Commission (IOSC)
-share markets - iNTERNATIONAL association of insurance supervisors (IAIS)
-insurance markets
main benefit of GFM
allow aussies access foreign capital for individual & business investment
enable aussies invest & earn returns from overseas bus
without access to inter finance, face higher borrowing costs/unable access finance easily
main disadvantage of integration with GFM
regular disturbances in market overseas quickly transmitted to AUS esp through financial market SPECULATION
results of financial market disturbances
4
- savings lost
- companies bankrupt
- undermine confidence across eco
- reduce eco growth
4 GVT bodies AUS responsible for regulation & supervision of financial system
- RBA
-responsible for monetary policy, payments system regulation, banking services to GVT, supply of banknotes, stability of financial system (5) - Aus Prudential Regulation Authority (APRA)
-prudential supervision & regulation of all deposit-taking institutions
-life & general insurance
-super funds - ASIC
-corp regulation
-consumer protection
-oversight of financial service products - AUS Treasury
-advises GVT on macroeco & financial stability issues
-advice for legislative & regulatory framework for financial system
Council of Financial Regulators CFR
coordinates collaboration among 4 members (RBA, APRA, ASIC, Treasury)
informal body allows info sharing & coordinating advice
-no collective powers separate from powers of individual members
late 1990s
RBA
AUS central bank, main role to ocnduct monetary policy & oversee stability of financial system
now, prioritieses sustaining low & stable inflation (og goal maintain stability of currency)
created 1959
central bank role 3
executing monetary policy on behalf of GVT
print banknotes
regulate country’s banking system according to eco objectives of Commonwealth GVT
how are central banks diff to other banks?
not set as financial business w/ desire to make profit
**legal monopoly privilege to issue banknotes **
doesnt provide accounts for general public
7 functions of RBA
- conducting MONETARY policy on behalf of GVT
-influence cost & availability of money in eco by influencing general lvl interest rates
-achieve sustained low inflation rate while encourage eco growth - financial system stability
-monitors risks & developments in AUS financial system
-conducts research & provides guidance to APRA to enforce regulations
-maintain long term stability of financial system by AVOIDING/reduce risk financial crises
other 5 functions of RBA
- control of note issue
-AUS currency manufacturer
-volume of notes & coins vary according to demand for cash - regulation of payments system
-payment methods (credit cards, electronic cash)
-promote stability in settling large transactions in financial markets -
banker to the banks
-hold ES accounts with banks
-accs allo**w banks to settle debts between themselves & RBA at end of day’s trading
-banks can use to buy & sell GVT securities from RBA - responsibility for holding AUS reserves of gold & foreign currency dealings
-provide funds used to make international payments/RBA operations in FEM
-oversees dealers in FEM - banker & source of financial & eco advice to GVTs
-banking & financial agency services to Commonwealth GVT & soem state GVTs
-can lodge excess funds w/ RBA & complete transactions on behalf of gvt (welfare, pensions) to citizens
-publishes** regular assessments of eco’s state & financial markets (sig influence policy making)**
ADI
authorised deposit-taking institutions from APRA
-banks, superfunds, insurance companies, credit unions, building societies
2 main regulatory roles of APRA
- ensures institutions meet obligatiosn to ppl placing money w/ em
-ensure deposit-holders can take back deposit money when wanted
-**superfunds perform well **& can pay ppl withdraw savings - sort out institutions financial position & ensure policy/deposit holders receive as much of their funds possible
ASIC has power to
monitor, investigate & act in situations where integrity of financial system undermined by illegal acts/unethical investment products
protect consumers against misleading/deceptive conduct affecting financial products & services
ASIC aims
**maintain high standards of corp behaviour & confidence in financial markets
offence regulated by ASIC: insider trading (company directors use non-public info abt company to buy & sell shares on market to make profit)
AUS Treasury role in functioning of AUS financial markets
main source of eco policy advice to GVT
-how they devise budgets, colelct taxes, allocate expenditure, implement policies (monetary, labour, market regulations)
for FINANCIAL MARKET
-advice to GVTs on regulatory settings for financial markets, corporate practices & consumer protection
price of money in the financial/money market
rate of interest borrowers pay
-not achieved through equilibrium of market forces alone but RBA influencing interest rates
mortgage
most common form of borrowing by households to purchase house
-lending bank gives house as security on loan
-if borrower defaults making repayments on loan, bank right to sell house to regain debt before giving leftover money to borrower
indivudal borrowing for short term borrowing
buying car, travel internationally, credit cards
-loans mostly unsecured, no asset financial institution can claim if borrower defaults on loan
-higher interest rate relative to those for mortgages
why does the business sector access msot funds of any sector in the economy? how do they borrow funds?
need access to funds to expand production, invest in R&D
-directly by issuing shares to raise equity/issue bonds to raise debt
-indirectly borrow money from financial isntitutions
-overcome downturns in its cash flow
how do GVTS participate in financial markets as borrowers
raise lvl eco activity
-slow growth rate –> funds readily vailable from financial markets –> borrow to increase spending/give tax cuts to stimulate eco
GVT spending grows faster than revenue (unintentional)/fund major infrastructure projects (decades so future returns from assets cover costs of investment)
liquidity
ease which financial asset can convert into cash so it can be used as medium of exchange
benefit of holding money, easy use of funds when necessary
when individuals have surplus funds what form can they decide to keep those funds?
hold money ( currency & bank deposits)
purchase financial assets (bonds/shares)
benefit of purchasing financial assets
return can earn by holding
-owners of shares in company can receive prop of profits made by company in dividends
-no return when holding cash (cash value erodes over time, money holds value)
RISKY THO
value can change depending on market conditions
3 reasons why some prefer holding money/highly liquid assets > invest surplus funds in financial assets offering return
TPS
-
transactions motive
-regular payments for g&s
-need certain quantity of currency for these transactions
-most financial assets cant be used to pay these -
precautionary motive
-unpredictable circumstances, emergencies for liquid funds -
speculative motive
-buying financial assets possibility making capital gains/losses
-value shares/bonds falls, capital loss
-avoid capital loss expect value fall, sell assets and convert to money)
how does lvl demand for liquid funds (money) depend on sophistication of financial system & ease one can convert non-liquid assets into money?
simple system, wanna hold more cash for transactions & precautionary purchases to easily access funds
-banks only operate brances & savings accs require holders to physically make transactions at bank,
advanced
-easier to convert financial assets into liquid funds
-ind&bus confidently hold more savings in less liquid assetswhen markets for assets have lots of buyers & sellers, function more efficiently
- affects demand, ease of electric transactions
main opportunity cost of holding liquid funds
interest wouldve been earned by holding financial assets
-benefit holding liquidity (lower costs for transactions, no risk of capital losses) > costs (interest), individuals wanna hold money than financial assets
demand for funds (during surplus) by businesses affected by factors
cash flow generated by business operations
whether cash flow sufficient to cover expenses
general eco conditions
-good –> more comfortable taking debt to fund major investments & expansion
low interest rates borrow more
payment method trends
electronic payment methods increasingly substitute for cash
-driven by ^availability & convenience (contactless card, mobile phone payments) more time efficient
why is AUS household debt increasing (mortgages)
-
long period of low interest rates esp 2000-10s
-when borrowing, main concern is how MUCH to pay back in monthly repayments
-afford to borrow more -
financial deregulation
-increased competition –> lowered borrowing costs & increased debt options to homebuyers -
rising income levels
-afford to buy bigger loans in dollar terms & as % of income - low inflation (avg)
6 financial innovation affecting consumer demand for liquidity (new tech)
- ATM, EFTPOS
- growth of internet based discount stockbrokers
-cheaper & easier for small ind investors participate in financial markets - rise of BUY NOW PAY LATER products offered by companies
-pay for goods in instalments w/o credit card/traditional loan -
MORTGAGE BROKERS
-help individuals find most suitable loan products
-replace banks as conduit to housing loan for large % borrowers -
CONTACTLESS PAYMENT systems
-pay without signing/providing PIN
-reduce transaction time > debit & credit cards - CRYPTO/digital currnecies
-future, transfer funds internationally quicker
-lower transaction fees < traditional methods
-transact directly w/o intermediaries (banks)
how are individuals lenders in financial markets
place deposits in financial institutions lend money to institution for return
-but hold wealth, not spend range options
-invest in assets/buy shares/avoid risk place money into interest-bearing deposit in bank
how can businesses be lenders in financial markets
successful business strong cash flow & profits but may not have wanna immediately expand/buy out another
-deposit funds in bank (FI)
-interest rates lvl where maintaining deposit funds likely more lucrative > investing in expansion, firm more likely deposit funds
how can GVTs be lenders in financial market
mostly borrowers, but surplus on budge, allows pay past debts/maintain positive financial balance (loan(borrow) money through financial sector)
why is the INTERNATIONAL SECOTR an importnat source of funds for domestic borrowers?
AUS historically low savings rates, relying overseas svings to finance domestic C&I
-borrow money from overseas foreign LIABILITY, must be repaid future
4 characteristics why money is important component of modern ecos
-
MEDIUM of EXCHANGE
-g&s, resources exchange for money - measure of VALUE
-compare relative value of g&s, resources -
STORE of value
-can be held over time & used predictably for future exchanges -
method of DEFERRED PAYMENT
-allows development of system of lending & borrowing
why is a stable monetary system important for the successful performance of an economy?
affect ability of markets to function properly & allow economy grow over time
- full employment
- eco prosperity & welfare
- stability of currency (more inflation now)
4 main ways money supply measured
-
CURRENCY
-held by households & businesses -
M1 = currecny + transactional bank deposits
- transactional bank accounts
-measure most liquid financial assets, used instantly to complete transactions - M3
-M1 + all non-transaction deposits
-consists of all currency in circulation & all private sector deposits in banks
-not as liquid as M1 -
BROAD money
-M3 + deposits in NBFI - NBFI in banks (credit unions, building societies) - holdings of bank deposits
M1 =?
M1 = Currency + transactional bank deposits
M3 = ?
M1 + NON-transactional bank deposits
BROAD MONEY = ?
M3 + NBFI deposits - NBFI deposits in banks
how is CREDIT an important FINANCIAL AGGREGATE (publishes &monitors data on the stock of money and credit) measured by thr RBA?
borrowers receive money upfront while lenders receive credit asset (have right to receive interest payments from borrower & amt moeny initially borrowed at end of loan period)
-credit itself loan asset banks & lenders hold
-not money but close
credit = value of total borrowing in AUS eco by HH & businesses
interest rates/borrowing rate
cost of borrowing money as % of total amount borrowed
-price brings equilibrium in financial market (quantity of funds supplied by lenders = demanded by borrowers)
rate of return(yield) on financial assets/instruments
supply of funds is in/elastic to changes in interest rate
inelastic
why do banks act as borrowers of funds when they accept savings deposits?
make profit
use funds to make profit by lending funds to other borrowers, charge interest on funds when make loans to customers
-profit by charging LENDING rate > BORROWING rate
borrowing rate & lending rate
difference between these rates
borrowing : rate of interest offered borrowed
lending rate: charge rate of interest by lenders
diff: interest rate differential
how do we distinguish betw short & long term interest rates?
based on length to maturity of financial assets/ securities
-eg. Comm GVT borrows funds using short term (<yr) securities or long term (bonds 5-10 yrs)
short term interest rates
interest rates on loans with maturity <1 yr
why interest rates diff betw long & short term securities
long term: riskier (can charge much more over time), less liquid (more diff to convert into cash)
-return required for assets usually higher , lenders receive higher interest rate
factors that influence general lvl interest rates
(factors affects supply/demand funds in financial markets lead to change in equilibrium lvl interest rates) ISLIGIM
-
demand for capital goods (investment)
-stronger investment demand –> higher demand for borrowing by firms to finance capital expansion, upward pressure on IR
-^ real wage rate (capital cheaper < labour)/^ lvl eco activity (firms need expand capcity to satisfy stronger demand) - lvl SAVINGS in eco
higher, ^ supply of loanable funds, downward pressure on IR -
demand for LIQUID FUNDS
-stronger pref, willing forgo returns from buying securities & choose hold funds in bank deposits/currency
-supply of loanable funds lower, put upward pressure on rate of interest - INFLATIONARY EXPECTATIONS
- GVT BUDGET
- INTERNATIONAL interest rates
- MONETARY POLICY
how do inflationary expectations affect interest rates
inflation reduces value of money & financial assets
-inflation expected to rise, lenders require higher IR paid as compensation for loss of value of financial assets
-if real rate of return(yield) on securities stays same, higher expected inflation –> higher nominal IRs in eco
how does GVT Budget affect interest rates
GVT budget deficit & borrower in FM –> higher IRs
-if GVT net lender in financial markets, DOWNward pressure on IRs
how do international interest rates affect AUS interest rates
capital markets open & funds move across national borders easily, lvl world interest rates impact domestic interest rates
-domestic IR < overseas IR, domestic lenders seek invest funds overseas to advantage higher rates of return yield
-reduce supply of loanable funds domestically, UPWARD pressure on domestic IRs
what type of influence monetary policy (RBA) on interest rates
manages cash rate
-DIRECT influences returns for SHORT-term loans & INDIRECT influence on interest rates on LONGER term loans
cash rate
interest rate in overnight money market (market for very SHORT term loans betw banks, loans made for overnight use many cases)
mechanics of cash rate & overnight money market is explained by 3 things
- exchange settlement accounts
- policy interest rate corridor
- open market operations
exchange settlement accounts
banks need to hold certain prop of their funds with RBA in ES accs to settle payments with other banks & RBA
-eg. consumer ANZ uses debit card to buy g/s from bus from westpac, funds need flow from ANZ to westapc for transaction through transferring funds bwtween banks ES accs
-banks end up having surplus/shortage funds in ES at end of day
-banks can hold ES balances in accs at RBA to store value
overnight money market banks have shortage of ES funds borrow money from banks with surplus, enables banks to settle interbank payment obligations each other
-like other FM, demand by borrowers & supply from lenders interact to set IR (equilibrium)
-supply of funds from lenders w/ excess ES increases, price borrowing this (cash rate) falls
-BUT RBA intervenes to enure cash rate sets targets using policy (IR) rate corridor & open market operations
policy rate corridor
RBA can ensure cash rate doesnt stray far from **target **w/ ES funds outside overnight money market
- RBA pays IR to banks on funds in ES accs 0.25 < target
-banks with excess ES balances dont have incentivce to lend funds to other banks as they could earn greater returns by leaving extra funds in ES account
-hence RBA’s deposit rate creates min value for cash rate - RBA always willing lend ES balances to banks outside overnight market
-sets IR on loans 0.25% above cash rate target
-banks need borrow ES balances not incentivised to pay rate HIGHER than RBA’s lending rate
-borrow ES funds directly from RBA outside overnight market
-creates MAX value for cash rate
together,** floor (RBA deposit rate)** & ceiling (RBA lending rate) form policy rate corridor for cash rate
-no banks (surplus/shortage of ES funds) have incentive to complete transactions in OMM outside of corridor
-actual cash rate always closely follows RBAS target
what is the policy rate corridor responsible for
implementing changes to RBA’s cash rate target bc ceiling & floor automatically set so cash rate target MIDDLE
-if RBA decrease target, floor & ceiling shift DOWNWARDS, banks borrow & lend from eahc other consistently with new target as soon as RBA announces changed target
borrowers & lenders always execute trades using the cash rate target. why?
cash rate target & actual almost same
-no reason why cash rate cant move within corridor
domestic market operations
demand for ES balances by banks fluctuate daily
-esp when large transactions/payments in eco (eg gvt pays social security benefits)
why does RBA manage lvl suppply of ES funds
it meets demand at price = target daily
without, cash rate bounces inside corridor whenever demand fluctuates
-but massive increase in ES balances no need for as many interventions
how does the RBA manage the supply of ES funds
conducting domestic market operations (DMO), RBA buy& sell financial securities in exchange for ES balances
-affect supply of ES funds used to complete transactions
-if demand for ES funds ^, RBA need to increase supply of ES funds to keep cash rate at target
domestic market operations
purchase & sale of financial securities by RBA in exchange for ES balances
HOW DOES THE rba INCREASE SUPPLY OF ES funds to keep cash rate at target
ibuy financial securities accounts
-increases supply of ES funds to meet additional demand
if DECREASE supply RBA sell financial securities to banks, exchange by withdrawing funds sitting in their exchange settlement accounts
-decrease supply of ES funds down to lower lvl of demand
DMO involves outright purchases/sales of securities (eg secondhand Comm GVT bonds) or repurchase agreements. what are repurchase agreements?
‘seller’ of bond/security agrees to buy bond/security back from ‘buyer’ at later date
SUMMARY of cash rate policy corridor
uses CRPC to change cash rate target
DOMESTIC market operations DMO to ensure CR stays target EVERYDAY when demand for ES funds change
both feature of OMM allow RBA control cash rate
what happens when the cash rate increases?
more expensive financial institutions to obtain funds in SHORT term money market
-increases overall cost structure of borrowing, flowing through LONGER term & mortgage IRs as banks try maintain profit margins
why is the cash rate important?
provides foundation of interest rate structure in economy
what happens during a reduction in cash rate
lowers cost of borrowing for banks in SHORT term money market
-financial institutions pass cost saving to customers in lower lending IRs
how do changes in general level of interest rates (caused by changes in cash rate) impact lvl of eco activity?
interest rates fall
-encourages C&I spending –> ^ lvl eco activity
interest rates rise
-deters C&I spending, reducing overall eco activity
what is the RBA’s influence on IRs to affect lvl of eco activity?
monetary policy
tighten by RAISING IRs or loosen by LOWERING IRs
