Question

Each Question is worth 15 marks (Total Marks: 60) Formula Sheet is provided at end of paper Question B1. (15 marks) "In terms of the outlook for Australian interest rates, the talk in recent months has all been about the next move being upwards. Booming employment growth and signs that business investment is picking up, along with strong economic conditions abroad and monetary policy tightening from the US Federal Reserve and Bank of Canada, has seen talk of rate hikes go from a whisper to a roar. Markets have priced in a rate hike by the end of the June quarter next year." (https://www.businessinsider.com.aurba-interest-rate-cuts-october-2017-10) a) Explain briefly why policy tightening overseas is relevant to the interest rate decision of the RBA. (Hint: Use the FX spot rate and its impact upon the economy in your explanation.) for the cash rate is relevant for long-term interest rates. diagram) if the market adjusts its expectations towards a rise in the RBA cash rate (4 marks) b) Use a suitable theory of the yield curve to explain very briefly why the RBA's decision (3 marks) c), Sketch a typical yield curve. Show how this yield curve changes (add a new one to your target next year (4 marks) d) Explain how the RBA increases the actual interest rate to reach-its target. Provide enough detail to cover ESF, cash rate, interbank overnightborrowing, OMO, and bonds. (4 marks)

Answer 1

a) The rate at which a currency pair can be bought or sold is known as the forex spot rate. Monetary policy tightening overseas leads to higher interest rates making it more attractive for investors to invest abroad. Countries with lower interest rates would thus experience a capital outflow. Hence, this would be relevant for RBA's interest rate decision. An interest rate hike for the RBA would make Australian exports more expensive while imports become cheaper.

b) The cash rate or the inter-bank rate is set by the RBA and is the rate of interest charged by banks when they lend to each other overnight. The effect of the change in cash rate on long term interest rates is influenced by expectations. Market expectations of interest rates determine the shape of the yield curves. A normal yield curve signals that the market expects the cash rate to rise and vice versa.

The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation,

c) A normal yield curve is upward sloping signifying that long term interest rates are higher than short term interest rates compensating investors for undertaking the higher risk associated with bonds of longer maturity.

TELD MATURITY

When the markets expect a higher future cash rate, and assuming that rates of maturity on all bonds go up by the approximately the same percentage points the normal yield curve experiences a parallel upward shift. It also flattens because the cash rate has more effect on short term interest rates. A flattening yield curve means that the difference between short term and long term rates shrinks.