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