Australian Monetary Policy - Interest Rates Slide Show for Australian Year 12 Economics Students

1. (c) Andrew Tibbitt 2019
Monetary Policy
Part 2 - Interest Rates
WACE Economics – Unit 4
Slideshow 14.2

2. (c) Andrew Tibbitt 2019
Determination of interest rates 1
Payment for a loan or borrowing
Reward for saving or lending
Rate of
interest
Quantity
Supply
(savings)
Demand
(borrowing)
Rise in borrowing

3. (c) Andrew Tibbitt 2019
Price of money
Rate of
interest
Quantity
Supply
(determined by
central bank)
Demand
(Liquidity preference*)
Rise in demand
for money
People demand more money
• to pay for more
transactions (shift)
• as security when things
are uncertain (shift)
• to avoid fear losing money
when bonds, shares and
houses fall in value (slope)
Determination of interest rates 2

4. (c) Andrew Tibbitt 2019
Lots of rates reflecting different:
• Time to maturity of loan
• Risk
• Expectations of inflation
• Expectations of exchange rate changes
But changes in cash rates are transmitted to other
financial and money markets and these rates change
as well.
There are many different rates of
interest

5. (c) Andrew Tibbitt 2019
Rates in housing markets follow a similar path to cash rates …

6. (c) Andrew Tibbitt 2019
… as do movements in rates charged to businesses

7. (c) Andrew Tibbitt 2019
The RBA sets a
target cash rate. It
then conducts
‘domestic market
operations’ to keep
market cash rates in
line with its target.
This happens by
changing demand
and supply in the
banks’ exchange
settlement accounts

8. (c) Andrew Tibbitt 2019
The cash rate is the rate charged on overnight loans
between financial intermediaries. It has a powerful
influence on other interest rates and forms the base on
which the structure of interest rates in the economy is
built.
Movements in the cash rate are quickly passed through to
other capital market interest rates such as money market
rates and bond yields.
The cash rate and other capital market interest rates then
feed through to the whole structure of deposit and lending
rates.
The structure of interest rates

9. (c) Andrew Tibbitt 2019
MONEY
MARKET
CASH BOND
MARKET
SHARE
MARKET
HOUSING
MARKET
Most Liquid Less Liquid
The liquidity spectrum
Money moves from one asset class to another as conditions change

10. (c) Andrew Tibbitt 2019
Yield curves

11. (c) Andrew Tibbitt 2019
A bond is effectively a Government or corporate IOU
Principal amount (issue price) e.g. $1000
Coupon Rate (interest set on date of issue) e.g. 5%
Coupon payment = dollar payment each year = $50
Second-hand market value of the bond depends on supply
and demand for it (length, risk, inflation expectations,
exchange rate movements)
Market value has inverse relationship with market interest
rate.
Bond market

12. (c) Andrew Tibbitt 2019
The bond market

13. (c) Andrew Tibbitt 2019
What happens to bond prices when cash
rates (and other rates) change?

14. (c) Andrew Tibbitt 2019
After change of market rates (say from 5% to 10%)
Market rate = 10%
Coupon rate = 5%
Coupon payment = $50
Market value = $500 so that the yield = 10% and matches
the market rate of interest.
Original situation
Issue price = $1000
Coupon rate = market rate = 5%
Coupon payment = $50
Yield = 5%
Bond price and market interest rates

15. (c) Andrew Tibbitt 2019
A change in cash rates leads to a change in other interest
rates.
Once the whole structure of interest rates has been
altered it takes a long time before:
1. Aggregate demand changes
2. Inflation changes
This is the second stage of the transmission mechanism
and is covered in the next slideshow.
Transmission mechanism

16. (c) Andrew Tibbitt 2019
End of Video 14.2
Next Video 14.3 Transmission