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FINS1612 SUMMARIES

Week 09
Introduction to Interest Rate determination and
Forecasting
1/4 - Macroeconomic context of Interest Rate
Determination:

By understanding the motivations of the central bank, participants of the


financial market can anticipate changes in a governments interest rate
policy.
o Lenders and borrowers can also make better informed decisions.

When does it increase interest rates (TIGHTEN monetary policy)?:


o Inflation above target range
o Excessive growth in GDP
o Large deficit in the balance of payments
o Rapid growth in credit and debt levels
o Excessive downward pressure on FX markets

What does it do?


o It eventually increases long-term rates
o Slows consumer spending (reducing inflation and demand for
imports)
o Decreases the size of the current account
o Possibly attract foreign investment, causing domestic currency to
appreciate
Note BOP ; The Balance of payments accounts are an accounting record of all

monetary transactions between a country and the rest of the world.

It has the current account which is a measure of net income.


o Balance of trade (net earnings on export minus payments on imports)
o Factor income (earnings on foreign investments minus payments
made to foreign investors)
o Cash transfers

Also the Capital/financial account which is net changes in national


ownership of assets
o Unlike the current account, a surplus in this account means that,
whilst funds are flowing into the country, it is from borrowing or sales
of assets rather than earnings.
o Similarly a deficit means the nation is increasing its claims on foreign
assets.

3 effects of changes in interest rates (1) Liquidity effect:


The effect of the RBAs market operations on the money supply and system
liquidity
o RBA increasing rates (tightening monetary policy) by selling CG
Securities

3 effects of changes in interest rates (2) Income effect:


A flow-on effect from the liquidity effect
If interest rates rise, economic activity will slow, allowing rates to ease.
o Increased rates reduce spending levels via effectively reduced income
levels.

3 effects of changes in interest rates (3) Inflation effect:


As the rate of growth in economic activity slows, demand for loans also
slows.
o This results in an easing of the rate of inflation.

Economic indicators Why?:


It is difficult to forecast the extent of liquidity, income and inflation effects
on changes in interest rates.

Especially when the business cycle is near a turning point (peak or


trough)

Economic indicators provide an insight into possible future economic growth


and the likelihood of central bank intervention.

However, it should be noted that it is difficult to know the extent of


the timing lead or lag as well as finding consistently
performing indicators
>>(rates of growth in money measures were once lead indicators and
are now lagging indicators)

Economic indicators:
Leading indicators:
o

Variables that change before a change in the business cycle

Coincident indicators
o

Variables that change at the same time as business cycle changes

Lagging indicators
o

Variables that change after the business cycle changes.

2/4 Loan-able funds approach to interest rate


determination:
As opposed to the macroeconomic approach (supply and demand of
money), the LF approach is preferred by many due to the conceptually
simple model.

LF are the funds available in the financial system for lending.

There is a downward-sloping demand curve and an upward-sloping supply


curve in the loan-able funds market

Interest rates rise, demand falls

Interest rates rise, supply increases


Demand for loan-able funds (B + G):

Business demand for funds (B)


o Short term working capital
o Longer-term capital investment

Government demand for funds (G)


o Finance budget deficits and intra-year liquidity

Supply of loan-able funds:

Savings of household sector (S)

Changes in money supply (M)

Dishoarding (D)
o Where hoarding is the
proportion of total savings
held in currency. Hence as
interest rates rise, people
purchase more securities
and dishoard for the
higher yield.

Equilibrium in LF Market:

E is the equilibrium point at rate i0

However, this is temporary as many factors cause the supply and demand
curves (which are not independent) to change;
o Level of dishoarding may change
o Money supply does not increase proportionally in subsequent periods
o There could be a change in business and/or government demand.

Some disturbances on Rates:

An increase in economic activity;


o Initial effect is that businesses sell securities. Yields increase (price
decreases thus) and dishoarding occurs

Inflationary expectations;
o The demand curve shifts to the right and the supply curve shifts to
the left, resulting in higher interest rates and unchanged equilibrium
quantity.

3/4 Term Structure of Interest Rates:

Yield is the total return on an investment, comprising interest received and


any capital gain (or loss)

Yield curve is a graph, at a point in time, of yields on an identical security


with different terms to maturity.

Normal/positive yield curve has higher interest rates for longer terms
than shorter terms.

Inverse / negative yield curve has higher interest rates for short-term

Hump yield curve has the shape changing over time from normal to
inverse,

Three theories of yield curve shape:


1. Expectations theory:
a. The current short-term interest rate and expectations about future
short-term interest rates are used to explain the shape and changes
in shape of the yield curve.
b. Longer term rates will be equal to the average (ARITHEMETIC NOT
GEOMETRIC) of the short-term rates expected over the period
c. The theory is based on assumptions, e.g.:
i. Large number of investors with reasonably homogenous
expectations
ii. No transactions costs and no impediments to interest rates
moving to their competitive equilibrium levels
iii. Investors aim to maximize returns
iv. and view all bonds as perfect substitutes regardless of term to
maturity

Normal yield curve occurs because future short-term rates will be


higher than current short-term rates.
Inverse yield curve results if the market expects future short term
rates to be lower than current short-term rates.
Humped yield curve is where investors expect short-term rates to rise
in the future but then fall.

2. Segmented Markets Theory:


This assumes that securities in different maturity ranges are viewed by
market participants as impacted substitutes (investors operate in a
preferred maturity range)
a. This rejects the assumption that investors have the same
expectations
b. It also rejects the assumptions that investors view all securities as
perfect substitutes.
The preferences of participants are motivated by reducing the risk of their
portfolios (exposure to fluctuations in prices and yields)
The shape and slope of the yield curve is determined by the relative
demand and supply of securities along the maturity spectrum.

Consider if the RBA purchased short term bonds, thus increasing the average
maturiy of bonds:

Short term yields decrease and long-term yields increase.


a. Areas of expenditure sensitive to short term interest rates will
expand.
b. Areas of expenditure sensitive to long term interest rates will
contract.
Expectations vs. Segmented markets:

Expectations theory would suggest that the RBA increasing the average
maturity would not affect expectations on future short-term rates and
hence not effect economy.
Segment markets emphasises risk management and hence denies
arbitrage opportunities (without which, extreme segmentation theory
would have discontinuities in the yield curve)
Segmented markets denies speculative profit (as actions for this are
dictated by expectations)
3. Liquidity Premium Theory:
Assumes investors prefer shorter term instruments which have greater
liquidity and less maturity (and hence interest rate risk).
Therefore they require compensation for investing long term
The compensation is called the liquidity premium (extra % return)

We can modify the expectations theory equation to


include the liquidity premi um theory;

4/4 Risk Structure of Interest Rates:


Default risk = risk that the borrower will fail to meet its interest payment
obligations.
o CGB are assumed to have zero default risk (they are risk-free and
offer a risk-free rate of return)
o Some firms and state governments etc might have greater risk of
default, hence they will have to offer higher rates of return for
bearing this risk.
How the risk premium effects yield curves:

Yield Curves for borrowers with different risk profiles:

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