Notes inclass 7

Interest rate determinants

Monetary policy

-monetary policy is an important tool used by governments to influence economic. Fiscal and monetary policy.

-The Reserve bank of Australia (RBA) sets the overnight rate in the interbank market (the cash rate) (started when the deregulation came in- floating of the exchange rate.) 1984.

-Changes in this rate then influence ADI (authorised deposit institution) deposit and lending rates thus directly impacting on the economy

Monetary policy- ultimate target

-is a variable the authorities seek to influence because of its welfare impact

-examples: lower inflation, higher employment, stronger growth

-intermeddiate target

-is used by the authorities because it can influence an ultimate target

RBA Market operations

-Cash rate (sets the benchmark)(risk free rate) (short term risk free rate)

+risk (adjusted rate) credit card (unsecured) +(On costs- establishing, monitoring, term, rate of return)

-ESA (overnight clearing account)

-Money Base= Currency+ balances in ESAs + other liabilities of the RBA to the private sector

The processes of monetary policy

-rba board formalises monetary policy objkectives

-announce cash rate monthly (first Tuesday)

-RBA carries out open market operations)

- this impacts on both the money base, cash rates and long-term rates

-impact on exchange rates and in turn on inflation and the real economy via the transition mechanisim

Objectives

-inflation target

-stabilitu of the Australian currency

-maintenance of full employment; and

-contribute to the economic prosperity and welfare of the people.

-monitor and dampen asset price bubbles.

RBA and budget imbalances

-rba can offset effects of budget deficit on the money base by selling foreign currency assets and / or domestic securities (CGS) to the private sector

-Opposite transactions will occur in the event of a budget surplus.

The yield curve

- relationship between yields of comparable securities (similar risks) across different maturities

-can take many different shapes:

-upward sloping, downward sloping, flat, humped.

Theories of yield curve

-liquidity or risk premium theory (longer term = greater compensation, sensitivity to price changes)

-segmented market theory (accessibility to different typs/ maturities of investments limited- particularly very long term securities in Australia)

Transmission mechanism

-define- the chnnels through which a change in rate (chage in interest rates) influences ultimate target variables (economic activity- prices, expenditure, employment)

The six main channels are:

-1. Exchange rate channel – increase R typically result in increase exhcnage rates- slow economy as imports cheaper and exports dearer.

-2. Term structure channel – expectations regarding future; e.g. decrease R may mean either that rates have bottomed or there is more downside to go

-3. Business investment channel- increase in r typically result in a decrease invcestment spending as RRR will increase to offset increase in borrowing costs.

-4. Asset price channel- property and share prices likely to fall with increase r resulting in lower consumptions

-5. Household spending- channel- increase r will decrease funds available for other purchases- households react by extending loan term and reducing impact

-6. Expectations channel – sterilised intervention

Overseas interest rates

-can affect domestic interest rates

-hong kong- fixed to us dollars (cannot influence their interest rates because pegged)

- Australian case: under high capital mobility with a floating rate, the local R has greater independence yet the currency will ultimately reflect differentials with world R (O/S rates increase then $A depreciate)

Inflation- another influence on rates is inflation. Definition- the ‘real’ interest rate is the rate after taking account of inflation as an approximation;

We write: rr= r- inflation rate; where rr is real rate, r is nominal rate..

Fisher effect

Nominal = real + inflation+ real rate x inflation

Nominal interests rate increase (relationship is posiotive)

Taxation and the fisher equation

-tax concessions aply to super funds, corporates who borrow, property investors. Other borrowers and lenders pay full tax.

-makes it difficult for authorities to target speculative activities (e.g. investment properties) as will target different parties to different extents. Ad velorum

After tax fisher equation: t= investors marginal tax rate.

Rrat= (1-t) r – inflation.

Makes it difficult for government to meet their objectives where