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Week 09
Introduction to Interest Rate determination and
Forecasting
1/4 - Macroeconomic context of Interest Rate
Determination:
Economic indicators:
Leading indicators:
o
Coincident indicators
o
Lagging indicators
o
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:
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.
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.
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,
Consider if the RBA purchased short term bonds, thus increasing the average
maturiy of bonds:
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)