Hey guys, just a few economics questions i have
Firstly, the cash rate, i cant seem to understand what its about, ive read the excel economics text, which wasnt very helpful, Dixons Global Economics text and the Get Smart! text all regarding the cash rate and asked my teacher but none seem to click, so could someone please try and explain it haha
also, will it be required to know recent up to date statistics relating to economics, such as the current CAD, Cash Rate, Interest Rates, Unemployment rates, so on and their recent trends?
and macro and micro economic policies, im pretty good with macro, but i was wondering what are examples of micro economic policies and with macro and micro policies, what are short term and long term ways of implementing them
Thanks, JT.
Ok, I will try to do my best to answer your question about the cash rate, but please feel free to ask any follow up questions.
As you may know an interest rate is essentially the price paid to borrow funds. It is usually charged at a percentage such that the amount that you pay is proportional to the amount that you borrow. The interest rate is determined by markets in the same way as the price for coal is determined on markets. I.e. the interest rate will depend on the amount of people willing to supply funds to be borrowed as well as the demand for funds within that market. This is a simple enough concept and one that I assume you are already aware of.
Financial markets consist of various buyers and sellers of securities and bonds. This is essentially how modern financial markets deal with people who wish to borrow funds, and those who wish to supply funds. For example if you wanted to borrow funds, you would sell a bond that would act as an IOU that indicates how much you will pay someone on some date in the future. A person who wishes to supply funds (invest) will buy your bond in order to receive the specified payment into the future. Because it is unlikely that someone will lend to you for free, the price paid for the bond on issue will be less than the amount that has to be paid into the future. E.g. the bond might say that $110 will be paid in 12 months time, and cost $100. This gives what is known as the ''yield to maturity'' which is essentially what the bond will earn its holder over the remaining life of the asset. So this would be $10 / $100 = 10% per annum for this example.
Now I have implicitly introduced a term structure. This is where things get a little bit complicated. Because the bond in this example must be repaid in 12 months, we would say that this has a maturity level of 12 months. But this could be for any length of time. Common maturity dates are 30 days, 3 month, 6 month, 12 month, 5 year and 10 year. In each case each maturity level offers a different ''yield to maturity'' (which is usually annualized so that they can be compared - i.e. expressed as per annum rates). So for a 30 day bank bill (equivalent to a bond) it might be 5% and for a 10 year bond it might be 7.5%. All that this means is that the amount by which the price of the bond is discounted from its face value can be different depending on the maturity of the bond (i.e. in this case a 10 year bond will be relatively cheaper to buy relative to its IOU value owing to a higher interest rate). So why do interest rates differ depending on the maturity level? Well this is where the cash rate comes in.
The cash rate is the shortest of all possible maturities. It is overnight (this is why it is called the overnight cash rate). Now this is essentially where bank's and other financial institutions borrow to make up any shortfalls in cash that they may need to operate the following day, or lend to earn a return on any surplus cash they may hold. This like the bond market consists of IOU's being sold between those who need to borrow, and those who have surplus funds. So how does the cash rate affect other rates? Well the pure expectations hypothesis of the term structure essentially says that the yield to maturity on longer rates are equivalent to the average of a series of shorter rates. For example, the 30 day bank bill rate is essentially made up of 30 x over night cash rates and forms the average of those overnight rates (likewise for say 10 year bonds and beyond). So if the 10 year bond rate is higher than the 30 day bank bill rate, this implies that interest rates are expected to rise into the future. Of course there are other things to consider like risk premia paid on longer maturity assets, but the key point is that the cash rate affects all other rates within the economy. This explains why the cash rate affects mortgage interest rates.
So finally how does the central bank influence the cash rate? well essentially the central bank controls the supply of funds within the overnight cash market buy purchasing and selling commonwealth government securities (CGS are the type of securities that operate within the overnight cash market). The RBA ensures that enough CGS are bought and sold such that the cash rate remains at its desired level. Contrary to what is stated in most textbooks this does not amount to the purchase of securities where it wants to reduce the interest rate and selling securities when it wants to increase interest rates. Instead the RBA does this on a second by second basis to ensure a particular cash rate is achieved. Whether they have to buy or sell depends on the level of demand and supply exhibited by other participants within the market. But it is certainly true to say that buying securities places downward pressure on interest rates and selling securities provides upward pressure where all other things are held constant.
Changes in the RBA's cash rate target affects the entire yield curve. Shorter rates will tend to increase by more than longer rates because longer rates are able to absorb the cash rate changes (as they are made up by many more over night rates). Longer rates may even respond negatively to changes in the cash rate if it builds up the credibility of the central bank and lowers inflationary expectations giving an impression of lower longer term rates. It all depends on how markets perceive a particular cash rate change. Sometimes (most of the time in fact) changes in the cash rate do not affect market interest rates at all as they are fully anticipated by markets and have already been incorporated into the prices of financial assets.
This has been a fairly in depth discussion, so please let me know if there is anything that confused you, but maybe this will provide more detail than the textbook or your teacher.
Regards
