Topic 4: Interest Rate Determination Flashcards Preview

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1

RBA

Is a central bank of Australia
Responsible for the implementation of the monetary policy

2

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

3

In most developed economies monetary policy actions are directed

at influencing interest rates.

4

Monetary policy decisions are expressed in terms of

a target for the cash rate, which is the overnight money market interest rate.

5

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

6

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

7

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.

8

Business Cycle

The change in economic activity over time through cycles of expansion and contraction

9

GDP

The aggregate value of goods and service produced within a domestic economy

10

Balance of Payments

A record of a country's transactions with the rest of the world

11

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

12

Method used by central bank to implement monetary policy

Open market operations

13

Three main open market operations

Buying and selling of government securities
Repurchase Agreements
Foreign currency swaps

14

Liquidity effect on interest rates

The effect on the money supply and system liquidity of a central banks open market operations

15

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

16

Inflaction effect on interest rates

As an economy slows, the upward pressure on prices will ease, thus allowing interest rate to fall

17

Economic indicators

provide market participants with insight into possible future economic growth and the likelihood of central bank intervention.

18

Three categories on Economic Indicators are

Leading Indicators
Coincident Indicators
Lagging Indicators

19

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.

20

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.

21

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 been doing poorly.

22

Asset

is a piece of property that is a store of value.

23

What determines the quantity demanded of an asset

Wealth
Expected Return
Risk
Liquidity

24

Wealth

the total resources owned by the individual, including all assets.

25

Expected Return

the return expected over the next period on one asset relative to alternative assets (e.g., bond return vs. stock return).

26

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).

27

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).

28

Liquidity Preference Framework

An equilibrium interest rate is determined by supply and demand for money

29

Define Money

Money is M1 (monetary based): includes cash, travellers’ cheques, and checkable bank’s deposit

30

Three motives for holding money

Transactions motive
Precautionary motive
Speculative motive