This document discusses how interest rates are determined and how monetary policy affects interest rates. It can be summarized as: 1) Interest rates are determined by the supply and demand of savings and borrowing in the economy. The central bank sets a target cash rate which influences other interest rates. 2) When the central bank raises the cash rate, it causes short-term market interest rates to rise. This leads bond prices to fall and long-term interest rates to also increase as bond yields rise. 3) Changes in interest rates spread throughout the economy as higher rates make borrowing more expensive and saving more attractive, which over time impacts aggregate demand and inflation.

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Slide 1
Monetary Policy
Part 2 - Interest Rates
WACE Economics – Unit 4
Slideshow 14.2

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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

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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

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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

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Rates in housing markets follow a similar path to cash rates

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as do movements in rates charged to businesses

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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

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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

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MONEY
MARKET
CASH BOND
MARKET
SHARE
MARKET
HOUSING
MARKET
Most Liquid Less Liquid
The liquidity spectrum

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Rate of
interest
%
Time
(Years)
Treasury
bonds
Blue chip
corporate
bonds
2 4
6
8
N ormal Yield Curves
Slope upwardsto the right.
The longer the loan the
higher the rate of interest.
The greater the risk the
higher the required interest
for all loans- yield curve
shiftsupwards.
Yield curves

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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

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Price of
bonds
Quantity
of funds
D1
S1
The supply curve for bonds shows
how the firms willingness to borrow
from the public changes as the price
of bonds changes.When the price is
high and the interest rate low it is
relatively inexpensive to borrow and
hence borrowingor supply will
increase.
The demand curve for billsshows
how the public’s willingness to lend to
firms changes asthe price of bonds
changes. When the price is low and
the interest rate is high lendingis
relatively attractive and hence the
amount of lendingor demand will
increase.
P1
public buy
bonds asaway
of lending
money to firms
firms sell bonds
asaway of
borrowing
money from
the public
The bond market

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Price of
bonds
Quantity
of funds
D1
S1
An increase in cash ratesaffects both
the demand for and supply of bonds.
A rise in the cash rate will cause some
firms that borrowed in the short-term
market to borrow from the bond
market (i.e.there will be an increase
in the supply of bonds).
Some lenders will now leave the bond
market and switch to the higher rates
on offer in the short-term market.
Thiswill cause adecrease in the
demand for bonds.
P1
public buy
fewer bonds
because cash
ratesare more
attractive
firms sell more
bondsbecause
borrowingat
higher cash
ratesismore
expensive
P2
S2
D2
What happens to bond prices when cash
rates (and other rates) change?

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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

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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

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End of part 2