and interest rates Presentation prepared by Taha Chaiechi Presentation prepared by JamesTroy Cook University Fuller andUniversity Edith Cowan Martine Mariotti ANU John Wiley and Sons Learning objectives
In this lecture you will learn:
the structure of the interest rate in the Australian Economy how the cash rate is determined in the overnight cash market, and how the RBA influences the cash rate. the reasons that central banks focus on interest rates rather than on money supply. Structure of interest rate in the economy There are different interest rates because borrowers riskiness differs from one individual to the next higher interest for higher risks. Maturity or maturity date: refers to the final payment date of a loan or other financial instrument. Maturity and interest rate relationship: one- year bank term deposits have shorter term to maturity and lower risk lower interest rate. Shorter maturity term always implies lower interest rate. 90-day bank bill is basically a type of loan among banks with 90 days to mature. Cash rate
The cash rate is the interest rate on overnight
loans among banks. For this reason it is sometimes called the interbank rate. Cash rate allows the RBA to adjust interest rates in the economy as deemed required. Whatever the interest rate, they tend to move together. Some key interest rates in the Australian economy
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The cash market and the cash rate Banks lend to consumers, firms and other banks. The cash market: arrangements for the purchase and sale of exchange settlement (ES) funds (or balances). The demand for ES is created by law. Open market operations: central banks purchase or sale of government bonds in the open market. Everyday a lot of cash gets transferred between banks. For example, your boss may pay your salary by transferring money from his bank account to yours. The system that allows this transfer is called exchange settlement funds. The cash market and the cash rate
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Demand for ES funds
Banks hold funds in their ES accounts.
They must make two types of payments: 1. Payment to government or agency (e.g. taxation) 2. Payment to other banks (e.g ANZ to NAB) Demand for ES funds
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Supply of ES funds
The cash rate is the equilibrium price in the
market for ES funds. It is the outcome of the supply and demand mechanism. RBA influences the demand for ES and also controls the supply of ES. To understand consider the following RBA balance sheet: Supply of ES funds
Supply of ES is controlled by RBA through
OMO (open market operation). The equilibrium cash rate is determined at the intersection of ES demand and ES supply. This equilibrium cash rate is the market clearing rate. Supply of ES funds
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The RBA and open market operations They are undertaken every business day. The RBA estimates the aggregate net settlement obligation between the RBA and ES account holders. The likely changes in ES balances are estimated for the day as a result. If ES balances are expected to fall the RBA announces an intention to buy securities, and creates sellers account. If ES balances are expected to rise the RBA announces an intention to sell securities, and creates buyers account. Equilibrium in the cash market
The RBA sets a target for the cash rate.
To achieve this cash rate, the RBA ensures the market clears at the equilibrium interest rate (i0). At i0, the quantity of ES funds supplied equals the quantity of ES funds demanded. The RBA is responsible for the supply of ES funds at the equilibrium cash rate. Equilibrium in the cash market
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Equilibrium in the cash market
Now assume the RBA decides to increase its
target for the cash rate. The RBA must determine the new supply level of ES funds which is lower than previous situation. The new cash rate is again determined by the intersection of new supply and demand for ES funds. The effect of an increase in the quantity of ES funds demanded Suppose that the demand curve for ES funds shifts rightward. If the RBA doesnt change the supply of ES funds then the cash rate increases. But if the RBA decides to keep the cash rate unchanged then it needs to increase the supply of ES funds. Increase in the supply is the shift of the supply of ES funds to the right by an amount that is equal to the shift in demand. Monetary policy target
The monetary policy target is the value of a
monetary variable that the RBA seeks to achieve. In Australia, the monetary variable is the cash rate. The RBA has a target value of the cash rate at any time. The statistics (since 1994) show that the periods of high ES balances generally occurred when growth of credit (bank loans) was slow. Also periods of low ES balances occurred historically with strong credit growth. Credit growth: the rate of the increase in loans of all kinds across the whole Australian economy. Monetary policy target
When credit growth is slow, economic activity
tends to be weak which causes the RBA to lower interest rates by expanding the supply of ES funds. Hence, the supply of ES funds seems to be high during low credit growth. Strong credit growth, on the other hand, occurred during the five years prior to the global financial crisis, which coincided with high economic activities. This caused the RBA to tighten monetary policy by reducing the supply of ES funds. Monetary policy target
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Money supply as an alternative monetary policy target Targeting the cash rate is not the only way to implement monetary policy. Central banks around the world have adapted alternative targets and operating procedures in the past 25 years. The main alternative is money supply that targets monetary aggregates. Central bank first decides on a target for money supply, and then provides the level of ES funds that leads to the desired level of money supply (monetary aggregate). Cash rate then would then adjust automatically. Monetary aggregates and monetary policy Monetary aggregates include : M1: all coins and notes held outside RBA + deposits of non-bank private sector in bank accounts on which checks can be drawn. M3: M1 + all other bank deposits of the private non-bank sector In the 70s, monetarist economists argued that by controlling M1, central banks then would be able to control total income (nominal GDP). In the 80s the link between nominal GDP and M1 broke down in many countries. Monetary policy practices
Central banks tend to control
interest rates to implement monetary policy. When the money supply increases, it will lead to a proportional increase in the prices (e.g. prices of factors of production) that is inflation. Case in point: Credit growth and nominal GDP
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Summary
By controlling the cash rate, the RBA can
influence the whole structure of interest rates that borrowers pay and lenders receive. The cash rate is the interest rate on overnight interbank loans of ES funds. The RBA can control the supply of ES funds which gives it control over the market price of ES funds (i.e. the cash rate). Open market operations can be used to achieve a target for the money supply.