Week 9: Interest Rate

Question 1

Investors required rate of return.

Answer 1

The present value of an asset is found by
•discounting the estimated future cash flows, back to the
•present value, using the
•appropriate discount rate

Appropriate discount rate
•Minimum rate of return an investor will accept from an investment, to
•compensate the investor for
•deferring current consumption to invest in financial assets.

Question 2

What are the 3 components for the investors’ required rate of return?

Answer 2

1. Real interest rates
2. Expected rate of inflation
3. Risk involved

Required rate of return (opportunity cost of capital).

Question 3

What is the real interest rate?

Answer 3

Pure time value of money, it is the reward for investors to defer the current consumption to a future date.

Real interest rate — is the basic interest rate in a world of no inflation.
=nominal interest rate - inflation rate

Nominal Interest Rate — Interest rate that prevails in the market =real interest rate + inflation rate

Question 4

What is the expected rate of inflation?

Answer 4

Rate of inflation - the annual percentage rate of change in the price level.

Usually measured by consumer price index (CPI).

There is a tendency for prices to increase over time.

Higher expected inflation
= greater return required by investors, to compensate them for loss of purchasing power.

Question 5

Fisher effect.

Answer 5

Real interest rate = nominal interest rate - inflation rate

Question 6

Risk premium.

Answer 6

Associated with “risky assets”.

Extra rate of return required to compensate investors with the uncertainty of the cash flows.
. The higher uncertainty, the higher the risk premium.

Financial asset risk is measured by the asset’s beta.
. The higher the beta, the higher the risk premium.

Question 7

RBA

Answer 7

The Reserve Bank of Australia (RBA) is responsible for monetary policy - i.e. setting interest rate

Monetary policy - Management by the RBA of liquidity conditions of the economy.

Liquidity conditions - Price (interest rate) and availability of funding for the economy’s expenditure.

Question 8

Aim of monetary policy.

Answer 8

Since the 1990s the practical aim of monetary policy has been to target an inflation rate of between 2 and 3% pa.

Decisions regarding the setting of monetary policy are made by the Reserve Bank Board at its monthly meeting

Question 9

How is the interest rate determined?

Answer 9

The Reserve Bank of Australia (RBA) is responsible for monetary policy (i.e. setting interest rates).

All commercial banks in Australia have to hold Exchange Settlement Accounts (ESA) with the Reserve Bank.
•these accounts are used to manage the flow of funds between commercial banks.

e.g. If a CBA customer pays $100 to a NAB customer by writing a cheque or doing a transfer via internet banking, the CBA’s exchange settlement account at the RBA is debited $100, and the NAB’s exchange settlement account at the RBA is credited $100

Question 10

Exchange settlement accounts.

Answer 10

Exchange Settlement Accounts (ESAs) are held with the RBA. They are used to manage funds flow between commercial banks.

Exchange Settlement Accounts (ESA)
. balances fluctuate on a daily basis due to the transactions between commercial banks
. commercial banks must maintain sufficient funds in their ESAs to fund daily transactions with other banks.

ESAs pay relatively low interest rates (commercial banks have little incentive to keep large balances in their ESAs).

Question 11

Overnight cash market.

Answer 11

Commercial banks access the overnight cash market to manage their ESA balances.

i.e. a market which facilitates the borrowing and lending for periods of 24 hours or less.

The interest rate which banks borrow and lend to each other is called the overnight cash rate.

Question 12

ESAs and overnight cash market.

Answer 12

A commercial bank with excess funds in the ESA can ken the money in the overnight cash market.

A commercial bank with a deficit ESA balance can borrow funds form the overnight cash market.

Question 13

Open market operations.

Answer 13

The RBA monitor the conditions in the overnight market, and
•influences the overnight cash rates, by
•intervening when necessary.

The RBA influences the cash rate (interest) towards their target by conducting open market operations
•buying and selling financial assets (usually government bonds) to the commercial banks.
•Manipulating the level of liquidity in the banking sector and thereby influencing the cash rate.

Question 14

Market operations explained.

Answer 14

RBA ➡️ (ESAs) Banks ➡️ (Loans) Public ➡️ (Deposits) Bank ➡️ (ESAs) RBA ➡️ repeats

Question 15

Changing the overnight cash rate (raising it).

Answer 15

RBA will sell financial assets to the commercial banks
(often government bonds).
•will lower the commercial banks’ ESA balances
•forces commercial banks to borrow from the overnight cash market
•increases the demand for funds, and
•increases overnight cash rates.

Question 16

Changing the overnight cash rate (lowering it).

Answer 16

RBA will buy financial assets from the banks (RBA often prints money to purchase these assets).
•will increase the commercial banks’ ESA balances
•creates an incentive to lend surplus funds in the overnight cash markets
•makes it easier for borrowers to negotiate a lower cash rate.

Question 17

Impact of RBA open market operations.

Answer 17

• By targeting the overnight cash rate, the RBA can affect other interest rates quite quickly.
• Longer term interest rates track the overnight cash rate very closely.

Question 18

RBA and real interest rates.

Answer 18

The RBA controls nominal interest rates by targeting the overnight cash interest rates.

Since inflation changes very slowly, any decision by the RBA in the short run to change the nominal interest rates will lead the real interest rate to change.
•e.g. if the nominal cash rate is 2.5%, and
inflation is 1.9%, real interest rates are 0.6%.
•if the cash rate increased to 2.75%, inflation would remain unchanged in the short term, so the real interest rate would be 0.85%.

Question 19

Why are interest rates so important?

Answer 19

Interest rates (both nominal and real) are components of the required rate of return, they directly affect the valuations of the assets.

•In the economy, real interest rates affect planned expenditure for both households, and businesses.

Question 20

Real interest rates.

Answer 20

When real interest rates are higher it:
•encourages households to save more and consume less, this reduces consumption spending.
•discourages firms from investing, since this increases their financing costs.

Together, higher real interest rates reduce both
•consumption spending, and
•investment spending.

The reverse holds true for lower real interest rates.

Question 21

The role of monetary policy.

Answer 21

Since the RBA can control (short term) real interest rates, and
real interest rates affect consumption and investment spending, the RBA can stabilise the economy through monetary policy.

In recessionary times:
•real output is below potential, and
•planned spending is too low.

To fight the recessionary gap, the RBA can reduce real interest rate to stimulate consumption and investment spending, which causes output to rise, and restoring the economy to full employment.

Question 22

Monetary policy and inflation.

Answer 22

An important cause of inflation is an expansionary output gap
•planned spending and actual output exceeds potential output.

In this scenario, firms find that the demand for their output exceeds their normal rate of production.
•some firms do not increase prices for their goods and services, in the face of excess demand, if high demand persists, they will raise prices, causing inflation.

To fight inflation, the RBA can raise real interest rates, which reduces consumption and planned investments.

This results in a decline output, an reduces inflationary pressure
RBA attempts to stabilise the economy by manipulating interest rates is referred to as POLICY REACTION FUNCTION.

The RBA’s choice of real interest rate depends on the state of the economy.

Question 23

Interest rates and share prices.

Answer 23

Higher interest rates increase costs and thus lower a firm’s profits.
–interest payments are an operating expense (accounting).
–lower profits drag down the share price.

Higher interest rates affect the level of economic activity and corporate profits.
–reducing corporate investment, and
–reducing consumer spending.

Interest rates affect investment competition between stocks and bonds.
–higher interest rates will reduce share prices, reducing the appeal of the share market, and attract funds to the bond market,

Experience has been that stock markets perform poorly when interest rates are high.

Impact on valuations
–present value of future cash flows is lower when interest rates are high (high discount rate means lower PV).

Question 24

Summary.

Answer 24

• Investors required rate of return is a function of inflation expectations, the real interest rate and risk.
• Nominal interest rate = real interest rate + inflation.
• The RBA uses open market operations to impact the cash rate, which flows through to other interest rates in the financial market.