T2 Answers -new - 2020 PDF

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Tutorial/Feedback Answers Topic 2: The Flow of Funds and Determination of Interest Rates Essay questions 1.

Interest Rates represent:  The cost of borrowing funds  The rate of return for lending funds  The opportunity cost of holding (hoarding) money  The time value of money 126

2.

0.06   20,000 1   12  

3.

(a)

0.062   ie  1   12  

(b)

0.06   ie  1   52  

4.

 $28,640.89 12

 1  0.0638  6.38%

52

 1  0.0618  6.18%

The level of interest rates is the overall position of interest rates in the aggregate (total) financial system. Interest rates can be referred to as being high or low, likely to increase or decrease, etc. The level of interest rate is determined by the demand for and supply of loanable fund in an economy. The structure of interest rates is the relationship between interest rates for financial assets that differ in a particular way. e.g. term to maturity, risk. The yield curve is one graphical representation of the term structure of interest rate using Government bond.

In

Aus instrument of government monetary policy is open market operations - the buying and selling of government securities in the secondary market by the Reserve Bank of Australia (RBA). In the conduct of monetary policy the RBA targets the cash rate; i.e. the rate paid for overnight funds in the professional market. For instance, an open market sales will lead to a decrease in the money supply and hence an increase in the cash rate, while open market purchases will lead to an increase in the money supply and hence a fall in the cash rate.

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Above is the result an open market sales. Changes to the cash rate will “normally” flow on to other interest rates bringing about a change in the overall level of interest rates. If other interest rates in the financial system such as bank deposit and lending rates and longer term security rates change by a greater or lesser amount, the structure of interest rates will also be affected. In some cases it is possible for longer term rates not to change at all or to even move in the opposite direction due to expectations as to future rates resulting from the monetary policy stance. 5.

The loanable funds theory of interest rates is determined by the supply of and demand for loanable funds, where loanable funds are the flows of funds into the market for securities. It is assumed that in relation to interest rates there is a downward-sloping demand curve and an upward sloping supply curve. Changes in the positions of the demand and/or supply curve will result in changes in the rate of interest, which can be caused through inflationary expectation, central bank action or global economic conditions.

6.

Late February 2011, Australia had a normal yield curve see the graph and ink below:

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Source: Bloomberg 2011. (as of 24 February 2011) http://www.bloomberg.com/markets/rates-bonds/government-bonds/australia/ 2 year – 5.03 5 year – 5.38 10 year – 5.57 The pure expectations theory would argue that this is due to market participants expecting short-term rates to increase in the future. Recent movements in the cash rate have been upwards and the markets be expecting further upward movement. RBA officials have expressed some concerns regarding level of inflation and the RBA is likely to increase its official target rate once the crisis caused by the flowed and cyclone in Queensland has eased. The link below will show you how the market expectation regarding the official cash rate can be captured: http://www.asx.com.au/sfe/targetratetracker.htm 7.

Market (pure) Expectations Theory This theory argues that the term structure of interest rates is determined by:  Current short-term rates (e.g rate for a 1 year treasury bond today)  Expected future short term rates (e.g rate for a 1 year treasury bond in one year, in two years) It postulates that long-term rates are the average of the expected future short-term rates over that period, because arbitrage will bring about such equilibrium. For this theory to hold:  Investors view financial assets with identical default risks as perfect substitutes for each other; e.g. bonds  Investors seek to maximise return, and will invest in whichever securities offer the greatest return  Financial markets operate efficiently and yields will move to their equilibrium rates Liquidity Premium Theory This theory assumes that financial assets with different terms to maturity are substitutes, but investors generally prefer short-term investments, because they have more liquidity and are subject to less risk. Borrowers will need to offer higher yields (a liquidity premium) to induce investors to invest long term. This liquidity premium will result in an “upward bias”

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for long-term yields, over and above what would be predicted under the market expectations theory. Segmented Market Approach Under the segmented market approach, financial assets with different terms to maturity are seen to be imperfect substitutes for each other, as different market participants have different preferences for the various markets. It is assumed that market participants seek to minimise risk, rather than maximise return, by matching the duration of their assets with the duration of their liabilities. The segmented market approach views markets for financial assets with different terms to maturity as separate markets with different supply and demand conditions. The equilibrium interest rate for each maturity will be determined by the interaction of supply and demand for that maturity. 8.

Australian Flow of Funds - Sectoral Balances

Sector

Traditional position

Exceptions

Households

net surplus sector

Periodically during 1990s and early 2000’s

Non-financial corporations

9.

net deficit sector

1992-93

Government

net deficit sector

1988-90, 1997 – 04, and early 2000’s

Rest of the world

net surplus sector

1972-73

Financial corporations

net deficit sector (small)

Frequent

The spread we are referring to here is the difference (spread) between the short-term rates (e.g. rate of 1 year treasury bond) and the long-term rates (e.g. rate of 5 year treasury bond). In theory when the yield spread is widened, it implies steepened yield curve. When yield spreads widen, banks are the big winners because the lower short dated yields mean they can borrow cheaply to fund short term obligations (using fund from our saving accounts for instance) when lending out long term to businesses and consumers at higher rate (long term loans).

10. Liquidity effect:

● the monetary policy actions of the central bank that impact upon interest rates, particularly the overnight cash rate ● central bank buys or sells government securities in order to affect the money supply and the level of liquidity in the financial system ● if the central bank buys securities from the financial system then there will be more cash in the system and interest rates will fall; an easing of liquidity

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● if the central bank sells securities into the financial system there will be less cash in the system as the investors pay cash to buy the securities and interest rates will rise; a tightening of liquidity

Income effect:

● refers to the flow-on effect from the initial liquidity impact on interest rates ● using the example of the central bank tightening liquidity and increasing interest rates in order to reduce the levels of spending in the economy ● reduced levels of spending will result in lower incomes in all sectors of the economy: the household sector, the business sector and the government sector ● this occurs as employment growth contracts, demand for goods and services eases, and taxation revenues to government decline ● as the rate of growth in economic activity slows, the demand for loans also slows ● the slowing in the demand for funds results in an easing in interest rates.

Inflation effect:

● in so far as the economy was previously experiencing inflationary pressures due to high levels of demand, now the slowing of the pace of economic activity will cause the rate of inflation to ease ● this easing allows rates of interest to ease as well ● the nominal rate of interest is said to comprise two components, being the real rate of return plus compensation for the expected rate of inflation ● if the rate of inflation is expected to fall, then market interest rates should fall

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