Finals Preparation Lecture 8 - An introduction to interest rate determination and forecasting Lecture 9 - An introduction to interest rate determination and

forecasting Describe the macroeconomic context of interest rate determination Monetary policy actions influence interest rates Understanding the motivation behind implementation of interest rate policy can allow borrowers/lenders to make better-informed decisions Goals of the RBA Maintain stable level of inflation Maintain GDP growth o Excessive growth leads to inflation Minimise unemployment Three effects of changes in interest rates Liquidity effect o The effect on money supply and system liquidity as a result of the RBAs market operations RBA increases interest rates by borrowing (selling CGS) Reduces liquidity because companies are paying for CGS Income effect o Flow on effect from liquidity effect Higher interest rates and lower funding available in the financial system means less spending Lower levels of income across all sectors Interest rates begin to ease Inflation effect Lower level of economic growth Lower inflation Indicators of economic activity In order to determine whether interest rate policy is appropriate and whether other interest rate action need to be taken, must look at economic indicators: Provides insight into economic growth and likelihood of RBA intervention o Leading indicators Economic variables that change BEFORE a change in the business cycle Housing loan approvals o Coincident indicators AT THE SAME TIME Industrial production o Lagging indicators AFTER Unemployment rates

Explain loanable funds approach to interest rate determination Another method of explaining and forecasting interest rates LF approach o Interest rates are determined by the supply and demand for loanable funds o Funds available in the financial system for lending Demand for loanable funds Business o Capital investment and ST working capital o Lower IR, greater volume of loans demanded downward sloping curve Government o Public sector borrowing when there is a budget deficit o Borrowing level is assumed to be independent of IR level vertical line D=B+G Supply for loanable funds Savings o Households o Higher IR, more households have incentive to save, funds provided for lending increases upwards sloping curve o Not a strong correlation therefore very steep curve Changes in money supply o Dictated by government market operations o Assumed to be independent of interest rate - parallel to savings lines Dishoarding o Hoarding - total proportion of savings held as currency o Dishoarding occurs (currency holdings decrease, funds available for lending increases) when interest rates increase because high yields can be obtained from purchasing securities Equilibrium in the LF market Only temporary equilibrium can be reached because supply and demand are not independent o Level of dishoarding will change o Money supply is unlikely to increase proportionately in subsequent periods o Changes in business and government demand Theories for term structure of interest rates Yield Return of an investment, including interest payments and capital gain/loss with reference to its current price Yield curve

Graph showing yields of an identical security with different yields to maturity

Shape of yield curve suggests that monetary policy is not the only thing that affects interest rates 3 theories to explain shapes of yield curves Expectation theory Segmented markets theory Liquidity premium theory Risk structure of interest rates Default risk - risk that the borrower will not be able to make back payments Zero default risk - assumed that there is no risk with lending gov. bonds have zero default risk Risk premium - investors require a risk premium for taking on risk above the risk-free rate