Macroeconomics – Monetary Policy

Monetary Policy

Interest Rate Effects

Liquidity Effect	IR affects RBA and bank transactions
Income Effect	Increase in interest rates lowers spending (greater cost of borrowing, greater benefit of saving)
Inflation Effect	Increase in interest rates raises the prices of goods

Fractional Banking and Money Creation

$1M in physical cash in bank
Assume a 10% reserve-deposit ratio, so keep 10% or 100K reserves to meet withdrawals.
Lend out 900K. That 900K is deposited. Money supply has increased to 1.9K. MS = currency in circulation (900K) + bank deposits (100K + 900K). Inflation has increased as price of goods increases (more D)

In effect, the loans/supply of money to the market are creating more money supply.

Velocity = value of transactions/money supply

The Role of Central Banks

Act as a bank to commercial banks (i.e. banks can deposit with CB)
Intermediary to allow banks to lend to and borrow from each other
E.g. in Australia, RBA targets a cash rate (nominal) by issuing bonds (asks for loans) or buying bonds (increases cash in circulation) to affect money supply
This is how RBA sets cash rate (through D & S of money). Cash rate is rate at which banks can borrow from CB.

Long-run money supply is perfectly inelastic – no matter how demand and prices change, the CB provides the same amount of money into circulation.

The market for loanable funds reflects the interest rates set by banks to consumers.

Bonds

Bond: Loan which can be trade
Can be government- or corporate-issued

Primary Market

Face value: purchase price, to be repaid at maturity

Coupon rate = fixed interest payment to maturity

Secondary Market

Market value: amount at which bond is currently traded

Affected by prevailing I/R. If I/R has risen since issue of bond, other bonds are more attractive so market value falls (discount)

Yield

Yield refers to return on investment (interest only or interest and capital gains).
There are two rates of return which are talked about when it comes to yields:

The Yield Curve shows the yield on identical bonds with different terms to maturity.

Liquidity Premium Theory states that investors prefer shorter-term, liquid bonds. Therefore there is an upwards bias built into long-term bonds, as investors need to be compensated for holding them in the long-term.

The bond yield curve plots the yield for various bond terms.

The yield is determined by:

cash rate, which influences the level (y-intercept) of the curve
difference between yields on short-term and long-term bonds, shown as the slope

Normal yield curve: indicates expectations of higher interest rates in the future. It is observed during times of economic expansion and inflation
Flat yield curve: similar yields on short and long-term bonds. May indicate stable economy or transition between normal and inverted curves
Inverted yield curve: future expectations of economic contraction, as the CB reduces rates when growth and inflation are low

Expectations Theory	Provides that future short-term rates can be determined by current long-term rates. E.g. if 1 year bond rates are 10% and 2 year are 12%, a 1 year bond rate in a year’s time will need to be 14% so that an investor who invests in two 1 year bonds will have the same yield as investing a a single 2 year bond.
Market Segmentation Theory	Different markets exist for short and long term securities as they are not substitutes – different investors prefer different maturities. Therefore, short and long-term rates are unrelated.
Liquidity Premium Theory	Investors prefer short-term instruments so a premium must be offered on longer-term instruments.