Interest Rates

What is an interest rate?

• An interest rate is the cost of borrowing money expressed as a percentage of the total amount borrowed

• One of the most important prices in the economy - the price which brings about equilibrium in the financial market

• It is the rate of return on financial assets or financial instruments such as bonds

How are they determined?

• Not really determined by the normal interaction of the forces of demand and supply like the prices of other goods and services in the economy

• In reality, the supply of funds (savings) is not very responsive to changes in the interest rate (very inelastic)

• Also, interest rates are indirectly set by the RBA through its impact on the cash rate (this is a special interest rate that we will discuss more about later)

Types of interest rates

• Financial institutions act as borrowers of funds when they accept savings deposits - they pay a “borrowing rate” on these funds

• Financial institutions act as lenders when they make loans to customers - they charge a “lending rate” on these funds

• The difference between the two rates is known as the “interest rate differential”

• Rates are also often distinguished based on the length to maturity of the financial assets or securities to which they apply (short term V long term interest rates)

Factors which affect the general level of interest

rates• The demand for capital goods. Stronger investment demand usually

leads to more demand for borrowing + increased interest rates

• The level of savings in the economy. A shortage of savings usually means there is a reduced supply of loanable funds - increasing interest rates

• The demand for liquid funds. If consumers need highly liquid funds they may be happy to forgo the returns that they could earn through buying securities.

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• Inflationary expectations. Inflation reduces the value of money. If consumers expect higher inflation they need to be compensated for the loss in value of their financial assets with higher interest rates

• International interest rates. If international interest rates are higher domestic lenders will lend funds overseas for a better return - reduction in loanable funds in Australia

• Domestic Market Operations by the RBA.

Domestic Market Operations (DMO)

• DMO - The instrument of government monetary policy

• Refers to the purchase and sale of “second hand government securities” (securities which have been previously issued)

• Conducted directly by the RBA with financial institutions through their ES (Exchange Settlement) accounts

• Banks hold a certain proportion of their total deposits with the RBA in ES accounts to settle payments with other banks and the RBA

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• The Overnight Money Market (market for ES funds) is where the banks borrow money if they need to add to their ES accounts or lend money if they have excess funds

• When the supply of funds held in the Overnight Money Market is too high, the price of borrowing this money (the cash rate) falls

• When the supply of funds held in the Overnight Money Market falls, the price of borrowing this money (the cash rate) increases

• If RBA wants to REDUCE the cash rate, it will BUY second hand government securities from the banks, and in exchange, DEPOSIT funds into their ES accounts (supply of funds increases)

• If RBA wants to INCREASE the cash rate, it will SELL second hand government securities to the banks, and in exchange, WITHDRAW funds from their ES accounts (supply of funds decreases)