Ch004_50afcfaf3166792224bc0b327e15c2fa.pptx

Module 4 The Reserve Bank and interest rates ©2018 John Wiley & Sons Australia Ltd  Chapter outline Money supply and tools of RB’s monetary policy/Te tuku moni cash rate / Ki ngā reiti huamoni Objectives of the reserve bank / Ngā Kaupapa o te pūtea matua o Ao...

Module 4 The Reserve Bank and interest rates ©2018 John Wiley & Sons Australia Ltd  Chapter outline Money supply and tools of RB’s monetary policy/Te tuku moni cash rate / Ki ngā reiti huamoni Objectives of the reserve bank / Ngā Kaupapa o te pūtea matua o Aotearoa How reserve bank’s policies affect economic activity / Me pehea te pānga o nga kaupapa here pēke rahui ki ngā mahi ohaoha Nominal versus real rates of interest / Te iti ia ngā reiti huamoni tuturu  Money supply The most important powers of the RB (Reserve Bank) is its ability to control liquidity in the financial system. ESFs (exchange settlement founds) are the funds used to settle obligations among the financial institutions and between the institutions and the RB. By controlling the ESFs, the RB is able to control the money supply. Money base is the value of currency held by the private sector plus the value of deposits made by banks with the RB (i.e., the  Measures of money supply M1 is the definition that focuses on money as a ‘medium of exchange (or transaction)’, such as currency held by the public and current accounts at depository institutions M2 is M1 plus EFTPOS transaction accounts M3, is the broadest monetary aggregate. Broad money is M2 plus savings and bank term deposits. M3 emphasises the role that money plays as a ‘store of value’.  Reserve requirements: Reserve ratio Reserve requirements refer to the amount of cash that banks must hold in reserve against deposits made by their customers. Reserve ratio (RR): The percentage that banks must keep in reserve and are not allowed to lend. Money supply = (1/RR) x Money base  Open‐market operations Open‐market operations include purchase or sale of securities by the RB in the money markets to maintain the cash interest rate consistent with its stance on monetary policy. LT or ST gov. bonds  Discount rates Discount window rates refer to the practice of some central banks to offer funds facilities to banks. They can increase their liquidity or loans business with the general public. For example, a bank holding bonds or notes might sell these back to the central bank at a penalty rate of return.  FX interventions The RB trades in the FX market with the intention of directly influencing or supporting the value of the currency. These FX interventions do have an impact on the money supply. For example, if the RB believes the home currency value is too high, it may sell the home currency (i.e., purchase foreign currency) in the FX market, increasing the amount of the home currency in circulation. This increases the money supply.  Chapter outline Money supply and tools of RB’s monetary policy Cash rate Objectives of the reserve bank Reserve bank’s policies Nominal versus real rates of interest  Cash rate The cash rate is the most closely watched interest rate in the economy (e.g., OCR in New Zealand). The cash rate is the unsecured overnight interbank lending rate and represents the primary cost of short‐term loanable funds. The cash rate is of particular interest because: ̶It measures the return on the most liquid of all financial assets ̶It is integral to monetary policy ̶It directly reflects the available reserves in the banking system.  Importance of cash rate The financial markets pay so much attention to changes in the cash rate mainly because changes in it reflect changes in monetary policy. When people have more money relative to their needs, they will spend more and thus will stimulate the economy. Conversely, if people have less money than they need, they will spend less. The cash rate and other short-term interest rates serve primarily as a signal of how monetary policy is proceeding.  Monetary policy The Board of the RB is responsible for the direction and management of monetary policy. The Board considers a wide range of economic data to come to its decision. Managing risk: RB’s impact on share and bond markets When there is an increase in market interest rates, the value of fixed‐income securities (e.g., bonds, notes and bills), which promise to pay predetermined fixed amounts, declines. If market interest rates decline, the value of all fixed‐income securities rises. There is a similar, but weaker, inverse relationship between interest rates and share prices. Most participants in financial markets constantly monitor RB policy actions to remain as fully informed as possible so that  Chapter outline Money supply and tools of RB’s monetary policy Cash rate Objectives of the reserve bank How reserve bank’s policies affect economic activity Nominal versus real rates of interest  Goals of monetary policy Governments are charged with the responsibility to achieve certain social, political and economic goals. – the stability of the currency and price level – the maintenance of full employment – the economic prosperity and welfare of the people (economic growth)  Price and currency stability Price stability refers to stability in the average price of all goods and services in the economy. Price stability and currency stability are virtually synonymous. Inflation is defined as a continuous rise in the average price level.  Full employment Full employment implies that every person of working age who wishes to work can find employment. The acceptable rate of unemployment depends largely on the actual unemployment rate. The actual unemployment rate in the early 1990s was at times more than 10%.  Economic growth Economic growth is expansion and development in an economy. Economic growth is made possible through increased productivity of labour and capital. Labour becomes more productive through education and training, and capital through the application of better technologies. GDP (Gross Domestic Product) growth rate  Other goals Apart from these three goals of monetary policy, the RB has other responsibilities. Through the Payments System Board, it has responsibility for the stability of the financial system. The Payment Systems Board must promote efficiency and competition in the payment services markets.  Possible conflicts among goals The conflict revolves around the perception that, as unemployment decreases, inflation usually increases. As the economy begins to expand, unemployment starts to decline as workers are called back to work. As unemployment decreases, there is higher demand in the economy because more people have more money. If production, for one reason or another, cannot expand fast enough, more money is chasing relatively fewer goods, so prices are bid up.  Chapter outline Money supply and tools of RB’s monetary policy Interest rates Objectives of the reserve bank How reserve bank’s policies affect economic activity Nominal versus real rates of interest  Economic activity Monetary policy is thought to affect the economy through three basic expenditure channels: ̶Consumer spending ̶Business investment ̶Net exports ( X – M, X=Export; M=Import) Businesses spend on investment in plant, equipment, new buildings and inventory accumulation. An increase in the money supply also means an increase in the quantity of funds available to lend.  Consumer spending A decline in interest rates in financial markets increases the market value of fixed‐ income securities (i.e., bonds). Consumer spending will tend to increase in response to an increase in the money supply.  Business Investment Business spending also tends to increase in response to lower interest rates and increased security values. Investors in new plant and equipment always consider the potential return on an investment and its financing costs. Business investment in inventory is also sensitive to the cost and availability of credit. When interest rates are low, firms and retailers are more likely to acquire additional inventory.  Net exports An increase in the money supply will also tend to cause a decline in the value of the home against foreign currencies. As the relative value of the home currency declines, the cost of imported goods increases for home consumers and the demand for imports declines. The cost of home goods declines for foreign consumers and the demand for exports increases.  Chapter outline Money supply and tools of RB’s monetary policy Cash rate Objectives of the reserve bank How reserve bank’s policies affect economic activity Nominal versus real rates of interest  What are interest rates? The price of money is called the interest rate and is usually expressed as an annual percentage of the nominal amount of money borrowed. To a person borrowing money, interest is the penalty paid for consuming income before it is earned. To a lender, interest is the reward for postponing current consumption until the maturity of the loan. Therefore, savers (investors) want to buy financial securities with the highest returns, whereas borrowers (issuers) want to sell Determinants of interest rates Determinants of interest rates In the supply‐and‐demand framework discussed, any economic factor that causes a shift in desired lending or desired borrowing will cause a change in the equilibrium rate of interest.  Real versus Nominal Rates The nominal interest rate is defined as the rate of interest actually observed in financial markets: the market rate of interest. Nominal rates – rates that have not been adjusted for inflation Real rates – rates that have been adjusted for inflation  Why adjust for inflation? The real interest rate excludes inflation. For example, if prices rise (inflation) during the life of a loan contract, the purchasing power of the dollars received back by the lender decreases. The value of money is its purchasing power — what you can buy with it. There is a negative relationship between changes in price level and the value of money As the price level increases (inflation) the value of money decreases.  Real rate of interest Fisher equation and inflation i = nominal rate, r = real rate The relationship between real rates, nominal rates, and inflation: Nominal % = Real % + Inflation % This equation is commonly referred to as the Fisher equation.  Restatement of Fisher equation The ‘derivation’ of the Fisher equation given above is an intuitive approach, leading to an approximation.  Fisher Effect Example If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? i = (1.1)(1.08) – 1 =.188 = 18.8% An Approximation: i = 10% + 8% = 18% Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.  Summary  The measures of the money supply  The tools of RB’s monetary policy  The goals of the reserve bank  How the reserve bank’s policies affect economic activity  How interest rates are determined  The relation between the nominal and real rates of interest.