Economic Management #11 Reserve Bank

[samvara]

Group Case Study done, some slightly fraught emails resulted in a printed, bound copy being handed in. Now to not think about the assignment and concentrate on everything else. Assignment was based on The City that Ended Hunger, an article on food supply.

Key Themes for seminar:

• Money supply and prices (inflation)
• Reserve Bank of Australia; role in influencing interest rates
• Link between interest rates and economy

Money and Prices

• Money supply is the currency held by the public (you and me) and current bank deposits (cheque and savings accounts)
• Close link between the amount of money circulating and the general level of prices
• Rapidly growing supply of money leads to quickly rising prices: inflation
  • headline inflation: Consumer Price Index
  • underlying inflation: CPI with outliers removed (e.g. spike in banana prices due to cyclone destroying crops)

Reserve Bank of Australia

1. Maintains stability of the Australian currency, which is regarded as maintaining low inflation via monetary policy (conducted in Australia by directly targeting interest rates)
   • affects interest rates by controlling overnight cash rate
   • meets 1st Tuesday of the month and announces target cash rate
   • conducts Open Market Operations to achieve cash rate
   • flow on affects mean longer term interest rates track the cash rate quite closely
2. Oversight and regulation of financial markets

Open Market Operations (OMO)

• Open Market Operations are the buying and selling of financial assets such as short-term government bonds in order to affect the level of reserves in the commercial banks' exchange settlement accounts
• Exchange settlement accounts are accounts the commercial banks hold with the Reserve Bank so as to manage the flow of funds from transactions between them - if the RBA wants to raise the level of reserves, they will buy financial assets from the banks.

Example of decreasing the cash rate:

1. RBA conducts Open Market Operations (buy financial assets = typically government bonds) from banks)
2. Changes balances in Exchange Settlement Account (credited by the RBA)
3. Banks borrow or lend in the overnight cash market (lend)
4. Affects the overnight cash market (more funds = fall in cash rate)

Interest rates affect where you store your money - is it better to keep it in cash, or invest it? Where should you invest it? Factors affecting the amount of money people want to hold at any given nominal interest.

• Real income or output (Y): as incomes increase, more money is required for a higher level of transactions. This increases the benefit of holding money
• The price level (P): the higher the price level, the more dollars are needed to finance the same volume of transactions.

Bonds

• Bonds are a method of raising finance available to businesses and governments
• Bonds are a legal promise to repay a loan, usually including a principal amount and regular interest payments. On issue, the agreed interest rate is called the coupon rate and the interest payments are called coupon payments. (like borrowing from the public)

Example: A person purchases a two-year bond with a principal amount of $1,000. It has a coupon rate of %5 per annum, so they will receive coupon payments of $50 at end of year one and $50 at end of year 2, plus the $1,000 principal.

• The bond's term, the credit risk and the tax treatment all influence the level of the coupon rate.
• Bonds do not have to be kept to maturity, and can be sold in the bond markets.
• The prices paid for bonds depends on current (not historical) market interest rates.

Person wants to sell their bond at the end of the year after receiving their first coupon payment.

1. How much can they get of the prevailing interest rate is now 6%?
   • If current interest rates on similar securities are 6%, the bond needs to return 6% too or no-one would buy it.
   • The coupon rate and principal payout on the bond are given, so the only thing they can alter is the bond price.
   • They will price the bond so the principle the buying pays will receive 6% and yet receive $1,050 at maturity.
   • $1,050 = bond price x 1.06; bond price = $990.57
2. How much can they get of the prevailing interest rate is now 4%?
   • $1,050 = bond price x 1.04; bond price = $1,010.

Interest Rates and Bond Prices

• If the interest rate is below the equilibrium market price for money, the demand for money is greater than the supply, which is the amount of money in circulation. e.g. low interest rates = put your money somewhere else = circulate it
• To increase money holdings, the public will start to sell of their bonds.
• An increase in the supply of bonds leads to a reduction in their price... which is equivalent to an increase in interest rates.
• Therefore the attempt to increase money holdings through selling bonds and other assets implies higher interest rates.
• At higher interest rates, the demands for money will declines, until equilibrium is reached where the money demands is equal to the amount of money available that that interest rate.

How Interest Rates are Changed

• Suppose the 90 day bill market starts in equilibrium, and the RPB conducts Open Market Operations to increase the overnight cash rate
• Firms who were planning to borrow overnight funds would now seek to borrow longer term funds elsewhere - including in the 90 day bill market
• This would raise the supply of 90 day bills, shifting the supply curve to the right.
• Some lenders will leave the 90 day bill market for the higher returns of the overnight cash market, shifting the demands curve to the left.
• The outcome is a lower equilibrium price, which corresponds to a higher interest rate.
• The RBA targeting an increase in the overnight cash rate has caused an increased interest rate in the 90 day bill market, and the same types of impacts would be felt in other financial markets.

Monetary Policy and the Economy
The principal medium-term objective of monetary policy is to control inflation, so an inflation target is thus the centrepiece of the monetary policy framework. The Governor and the Treasurer have agreed that the appropriate target for monetary policy is to achieve an inflation rate of 2–3 per cent, on average, over the cycle. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private sector inflation expectations.

Hotlinking from RBA website.

Targeting interest rates

• The RBA controls monetary policy by setting the overnight cash rate to a target and allowing all the other interest rates in the economy to adjust.
• The RBA cannot control both the overnight cash rate and the money supply to achieve their target interest rate.
• Assume the RBA achieved a target cash rate and a specific target money supply
  • If demands for money increase, the demands for money function would shift to the right
  • People want to hold more money at the interest rate. If the RBA left the money supply unchanged, people would start to sell bonds to do so.
  • The price of bonds would decrease, which increases the interest rate (inflation).
• If the RBA were willing to buy the bonds that were offered for sale at the existing price, there would be no change in their price and therefore the interest rates.
•  The RBA pays for them with newly issued money and therefore the money supply increases.
• There fore, the RBA allows the money supply to change to maintain a target interest rate.
• The money supply curve is effectively a horizontal line at the target interest rate.

Nominal versus real interest rates

• The inflation rate changes relatively slowly in the short term, therefore changing the nominal rate tends to change the real rate.
• So in the shirt run, the RBA controls real rates through control of nominal rates.
• In the long run, the RBA has less control because real rates are determined by the supply and demands for saving and investment.

Planned Consumption Expenditure and the Real Interest Rate (that's never going to fly as the name of a band)

The level of real interest rates in the economy affects planned aggregate expenditure.

• A rise in interest rates reduces household consumption expenditure through
  1. Encouraging households to save more as the reward for saving increase
  2. Discouraging household spending that would be financed by credit (e.g. consumer durables)
• A rise in interest rates reduces investment expenditure through
  1. Increasing the cost of borrowing reduces the profitability of business investment in capital equipment.
  2. Increasing the cost of mortgages for residential housing.

Planned Aggregate Expenditure and the Real Interest Rate

At any given level of output, both investment and consumption spending decline when real interest rates increase. The converse is true when real interest rates decrease.

The RBA can use changes in the real interest rate to eliminate output gaps and stabilise the economy.

...and then we ran away... .actually we did discussion exercises on budgets and contingent funds.