Short term interest rates

Question 1

Factors affecting short term interest rates

Answer 1

Short term interest rates are largely controlled by the government through central bank
intervention in the money market
o The central bank will set benchmark short term rate at which it is prepared to lend in
the market
o All other short term interest rates ( including those at which banks and other
financial institutions are prepared to lend at ) will be related to benchmark rate
o By controlling the benchmark rate, the central bank is therefore able to control the
level of short term interest rates throughout the economy
- Government sets interest rates directly and indirectly in attempt to meet its policy
objectives depending on relationship between government and central bank :
o Central bank could have complete independence from government – setting
monetary policy
o Decision could be exclusive domain of government power
o Central bank may enjoy a degree of independence when setting short term interest
rates , while subject to constraints such as hitting particular target inflation level

Question 2

Main reasons for altering interest rates part 1:

Answer 2

▪ Controlling economic rates
o Low interest rates mean no incentive to save money- increase consumer spending
o Low interest rates means lower cost of borrowing money for company expansions
and spending – encouraging investment spending
o High spending in the economy
o Increases aggregate demand in the economy
o Hence, high economic short term growth
▪ Controlling Inflation
o There is a direct relationship between the quantity of money in the economy and
the level of prices of goods in that economy ( quantity theory )
o Reduced interest rates, increased demand for credit from banks , there is an
increase in supply of money in the economy which can lead to inflation

Question 3

Main reasons for altering interest rates part 2:

Answer 3

▪ Controlling Exchange Rates
o If the interest rates are lower or higher relative to other countries
o Affects demand for the currency of that economy – inclined to deposit money
o Which in term affects the strengthening or depreciation of the exchange rates
o May affect cost-push-inflation where imports of raw materials are high, and costs go
up and firm decide to pass on the increase to consumers through higher prices
o Sources of cost-push inflation
▪ Higher import price due to weakening of the domestic currency
▪ Higher import price for other reason – rise in price of oil
▪ Higher wage demand not met by productivity increases

Question 4

What is quantitive easing?

Answer 4

• Cutting of short term interest rates can be used by the government as a means to
  temporarily increase the economic growth in the economy
• Where the interest rates are already low close to zero, the government may have to find
  alternative ways of influencing growth in the economy
• Quantitative easing works as follows :
  o The central bank creates money electronically and uses it to buy assets ( usually
  government bonds from the market )
  o This purchase increases the supply of money in the financial system , which
  encourages banks to lend more ( they have more money )
  o Purchase of assets can also reduce returns on the money market and bonds
  ▪ Buying back bonds means there are now fewer bonds remaining in the
  market
  ▪ The prices for the bonds will rise and returns on assets will be lower
  reducing the appeal on the assets
  o Investors may look into investing in other assets with higher yield such as equities
  and property
  o More capital available for companies to expand and grow
  ▪ Due to Low interest rates also reduce the costs of borrowing ( lower interest rates)

Question 5

Factors affecting the level of bond market:

Answer 5

• Supply of bonds is primarily from the government , but also from corporate borrowers
• Demand mainly comes from the institutional investors ( including overseas investors )
• Factors that affect supply and demand for bonds will affect the bond yields and hence the
  level and shape of the yield curve ( actual change and expectations )

Question 6

Factors affecting short term interest rate (list)

Answer 6

• Inflation
  o expectation of high inflation are likely to lead to higher bond yields (expectation
  theory )
• Short term interest rates
  o Related to expectation theory and inflation risk premium theory
  o Affect the short end of the yield curve – long term effect not clear cut out
  o Short term interest rates are closely related to the returns on money markets
  instruments
• Fiscal deficit
  o Greater deficit, means greater supply of government bonds
  o Putting upward pressure on the bond yields especially at durations in which
  government is concentrated most of its funding
  o The effect will be the same no matter the form of funding policy used – treasury bills
  or printing money
• The exchange rates
  o Demand for government bonds will come from overseas
  o Change in expectations of future movements in exchange rates will affect demand
  o It will alter attractiveness
• Institutional cashflow
  o If institutions have an inflow of funds because of increased levels of savings
  o They are likely to increase demand for bonds, increasing prices reducing bond yields
• Change in regulation
  o Will affect the institutional demand for bonds
• Change in investment policy – investment strategy
  o Will affect the institutional demand for bonds
• Other economic factors
  o economic or political news ; ratings downgrade or upgrade
  o These could be news that have implications for inflation and short term interest
  rates
• Returns on alternative investments
  o The relative attractiveness of alternative investments , both home and overseas will
  influence the demand for bonds and hence the yields they offer