FINS1612 Lecture Notes - Lecture 9: Open Market Operation, Financial Market Participants, Root Mean Square
Friday, 5 May 2017
Capital Markets & Institution
Interest Rate Determination
-In most developed economies, monetary policy actions are directed at influencing
interest rates
-By understanding what motivates central bank in its implementation of interest rates
policy:
•Financial market participants can anticipate changes in a government’s interest rate
policy
•Lenders & borrowers can make better-informed decisions
-Central bank may increase interest rates if there is:
•Inflation above target range
•Excessive growth in GDP
•Large deficit in BOP
•Rapid growth in credit & debt levels
•Excessive ‘downward’ pressure on FX markets
-Increase in interest rates (ie tightening of monetary policy) will:
•Eventually increase long-term rates
•Slow consumer spending - reducing inflation & demand for imports
•Decrease size of Current Account
•Possibly attract foreign investment, causing domestic currency to appreciate
-Three Effects of Changes in Interest Rates:
1. Liquidity - effect on money supply & system liquidity of a central bank’s open
market operations
•E.g. higher interest rate leads to reduction in liquidity in financial system
2. Income - if interest rates rise, economic activity will begin to slow & incomes will
fall, thus allowing rates to begin to ease
•As interest rates rise, economic activity will slow & incomes fall
3. Inflation - As an economy slows, upward pressure on prices will ease, thus
allowing interest rates to fall - results in easing of rate of inflation
!1
find more resources at oneclass.com
find more resources at oneclass.com
Friday, 5 May 2017
•Difficult to forecast extent of liquidity, income & inflation effect on changes in interest
rates
-Particularly when business cycle is about to change (ie at a peak or trough)
•Economic indicators provide an insight into possible future economic growth &
likelihood of central bank intervention
-Economic Indicators:
•Leading indicators - economic variables that change before business cycle changes
•Coincident indicators - economic variables that change at same time as business
cycle
•Lagging indicators - economic variables that change after business cycle changes
•Difficulties exist with:
-Knowing extent of the timing lead or lag of such indicators
-Consistently performing indicators (e.g. rates of growth in money measures were
once lead indicators, now lagging indicators)
-Loanable Funds Approach to Interest Rate Determination:
•Preferred way of explaining & forecasting interest rates - preferred by financial
market analysts & a conceptually simplistic model
•Alternatively, macroeconomics uses supply & demand of money to explain rates
•Loanable Funds: Amount of funds available for lending within financial system
!2
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
In most developed economies, monetary policy actions are directed at in uencing interest rates. By understanding what motivates central bank in its implementation of interest rates policy: financial market participants can anticipate changes in a government"s interest rate policy, lenders & borrowers can make better-informed decisions. Central bank may increase interest rates if there is: in ation above target range, excessive growth in gdp, large de cit in bop, rapid growth in credit & debt levels, excessive downward" pressure on fx markets. Three effects of changes in interest rates: liquidity - effect on money supply & system liquidity of a central bank"s open market operations, e. g. higher interest rate leads to reduction in liquidity in nancial system. Income - if interest rates rise, economic activity will begin to slow & incomes will fall, thus allowing rates to begin to ease: as interest rates rise, economic activity will slow & incomes fall.
