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MAF202 Topic 4 Seminar Solutions

MAF 202 Money and Capital Markets Solutions: Topic 4 Interest rate Determination – Liquidity and Loanable Funds Theories Please note that the following suggested answers incorporate the main points that should be recognised in an answer.

Topic 4 – Essay Questions from Custom Text Chapter 11 Question 1 Within Australia the Reserve Bank is responsible for the implementation of monetary policy. The central banks of other developed economies also have similar responsibilities. Briefly identify and discuss a range of issues that a central bank would consider when monitoring its current monetary policy settings. Current monetary policy is principally directed towards containing inflation within a target range of 2 to 3 per cent over the business cycle. In directing its policy decisions to achieve this objective, the central bank will consider: • the underlying rate of inflation over the business cycle • the rate of employment / unemployment / employment growth • the stability of the currency – in particular relative to major trading partners • the welfare of the people • the current economic environment / business cycle • current monetary policy settings • the direction of economic growth • the impact on past monetary policy settings on current and future economic growth • time delays between a change in monetary policy settings and a change in economic growth • economic fundamentals in major trading partner countries • forecast changes in international economic growth

Question 3 Market participants, including financial institutions, funds managers and corporations, must understand monetary policy setting impacts on economic activity and the business cycle. A central bank will typically

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MAF202 Topic 4 Seminar Solutions implement monetary policy settings in order to achieve certain economic outcomes over a business cycle. In order to forecast future economic conditions and business activity, business managers therefore need to understand the business cycle. (a) Briefly describe the principal monetary policy objective of the Reserve Bank of Australia. (b) Draw a diagram and explain the structure of a business cycle over time. (c) Discuss and give examples of different economic indicators that may give an insight into the future stages of a business cycle. Discussion part a) The principal objective of current monetary policy is to implement monetary policy initiatives that contain inflation within a target range of 2 to 3 per cent over the business cycle. Discussion part b) • The business cycle is a measure of changes in the level of economic activity in an economy over time. • It tends to move in changing cycles of peaks and troughs. • Business cycle peak—the highest level of economic activity during a cycle. • Business cycle trough—the lowest level of economic activity during a cycle •

Economic

Peak

Business cycle Trough Time

Discussion part c) • Economic indicators are constructed from a set of historic data that provide some insight into possible future economic growth. • Leading indicators—economic variables that change before there is a change in the business cycle. • Coincident indicators—economic variables that change at the same time as the business cycle changes. • Lagging indicators—economic variables that change after there is a change in the business cycle.

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MAF202 Topic 4 Seminar Solutions There is a wide range of economic indicators. Governments, central banks, corporations and analysts will select a number of indicators that best inform them, including: • the rate of inflation over the business cycle • the rate of growth in gross domestic product • the balance of payments • credit growth and associated debt levels • the exchange rate relative to major trading partner currencies • the rate of unemployment, job vacancies and ratio of full-time and part-time employment • the balance of payments, imports and exports growth • finance for housing, residential and non-residential building approvals • economic activity and capacity utilisation • wages growth and overtime worked • retail sales • share price movements.

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MAF202 Topic 4 Seminar Solutions

Topic 4 – Questions from Mishkin Chapter 5 Question 1. Explain why you would be more or less willing to buy a share of Polaroid stock in the following situations: (a) Your wealth falls? •

less, because your wealth has declined

(b) You expect the stock to appreciate in value? •

more, because its relative expected return has risen

(c) The bond market becomes more liquid? •

less, because it has become less liquid relative to bonds

(d) You expect gold to appreciate in value? •

less, because its expected return has fallen relative to gold

(e) Prices in the bond market become more volatile? •

more, because it has become less risky relative to bonds

Question 7 “No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquidity than another security.” Is this statement true, false, or uncertain? Explain your answer. True, because for a risk averse person, more risk, a lower expected return, and less liquidity make a security less desirable. Question 10 What effect will a sudden increase in the volatility of gold prices have on interest rates? Interest rates will fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase. The demand curve, D1, shifts to the right and the equilibrium interest rate falls. Question 12 Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer. Yes, interest rates will rise. The lower commission on stocks makes them more liquid relative to bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium interest rate will rise.

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MAF202 Topic 4 Seminar Solutions Additional Question. Using both the liquidity preference and loanable funds frameworks, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions). • In the loanable funds framework, when the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. • Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. • When the economy enters a recession, both the supply and demand curves also shift but to the left, and the demand curve shifts less than the supply curve so that the interest rate falls. • The conclusion is that interest rates rise during booms and fall during recessions: that is, interest rates are procyclical.

•

The same answer is found with the liquidity preference framework. When the economy booms, the demand for money increases: people need more money to carry out an increased amount of transactions and also because their wealth has risen.

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MAF202 Topic 4 Seminar Solutions The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. When the economy enters a recession the opposite occurs. • The demand for money falls and the demand curve shifts to the left, which results in the lowering of the equilibrium interest rate. • Again, interest rates are seen to be pro-cyclical.

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Interest Rate, i

M

s

2

i2

1 i1 M M M

d 2

d 1

Quantity of Money, M

True/False questions 1 T

2 F

3 F 4 T 5 T 6 F 7 T 8 F

Initially, an easing of monetary policy will result in a fall in interest rates, but as economic activity increases, the income and inflation effects are likely to result in an increase in interest rates. Economic indicators such as the level of employment provide market participants with clear and certain indication as to the future direction of economic activity and growth. A coincident economic indicator is one that might be used to indicate the future direction in which the economy is headed. In the loanable funds approach to interest rates, the demand for funds originates from the business sector and the government sector. The supply of loanable funds is derived from the savings of the household sector, changes in the money supply and dishoarding. An increase in the money supply would permanently shift the supply curve of loanable funds to the right. Dishoarding is generally more evident when interest rates in the market have increased. The government sector demand curve in the loanable funds approach is downward sloping, with the slope changing in response to the size of government

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MAF202 Topic 4 Seminar Solutions

9 T

10 F

11 F

12 T

13 F 14 T

15 F

16 T

17 T

18 F 19 T

20 F

expenditures. With the loanable funds approach to interest rate determination, the demand and supply curves are not independent of each other; therefore it is not possible to accurately determine a unique equilibrium interest rate. Applying the non-Fisher outcome to the loanable funds approach, an increase in inflationary expectations will result in an increase in interest rates equal to the increase in inflationary expectations. The long-term yield curve is a single curve at a point in time that shows the various interest rates for different terms to maturity on all fixed-interest securities issued by governments and corporations. When the central bank implements tight monetary policy, an inverse yield curve should occur as short-term interest rates will be higher than longer-term interest rates. The various theories of interest rate determination are independent of each other and market participants usually adopt one theory when analysing interest rates. Under the expectations theory of the yield curve, longer-term interest rates are a function of the current short-term interest rate and forecast future short-term interest rates that will exist over the longer term. Using the expectations approach, a bank is offering a one-year term deposit interest rate of 4.75 per cent per annum, and a two-year rate of 5.25 per cent per annum. Therefore an investor should expect that in 12 months’ time the new oneyear interest rate will have increased to 5.25 per cent per annum. Under the segmented markets approach to explaining the yield curve, an increase in the supply of short-term instruments and an equal reduction in the supply of long-term instruments would cause the short end of the yield curve to rise and the long end to fall. The liquidity premium theory suggests that investors will demand a higher rate of interest to induce them to buy long-term instruments so that they will be compensated for increased risk and loss of liquidity. The existence of an inverse yield curve indicates that investors are not demanding a liquidity premium in periods of tight monetary policy. The risk structure of interest rates includes a margin for default or credit risk for each corporate debt issuer. A corporation with a AA– credit rating will pay a lower risk premium than a corporation with a BBB+ credit rating. The risk-free rate of interest is the yield paid on longer-term securities issued by corporate borrowers that have an investment-grade credit rating.

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