Chapter 13 Introduction to Interest Rate Determination and Forecasting

Interest rate
main tool in implementing monetary policy through open market
operations
are price of money (yields on investment and cost of borrowing depends on
the interest rates)
13.1 Macroeconomic context of interest rate determination
-

Central banks are responsible for determination and implementation of

monetary policy using interest rates as a main tool through open market
operation (increase or decrease the cash rate)
AIM: Maintain the inflation within a target range then a wide range of
economic objectives can be achieved
Check on economic activity level change interest rates

E.g. Central bank will increase the interest rates if:

a) Rate of inflation over the business cycle is above the target range
b) Rate of growth in gross domestic product is excessive
c) Current amount of the balance of payments is significantly deficit
d) credit growth and associated debt levels are expanding too rapidly
e) there are ongoing and unsustainable price increases in major economic sectors such
as the property sector or the mining sector
f) currency is under excessive downward pressure in the foreign exchange markets
Central bank increase interest rates (higher rates maintain for some time) medium
to long term interest rates will also increase
-

tightening of monetary policy is to slow spending in the interest-sensitive

areas of the economy.
Spends slow position of suppliers of goods and services will weaken the
rate at which the suppliers increase their prices should also fall rate of
inflation decline
(interest supplier so
rate of inflation decline, price decline)
(inflation increase, every dollar you own to buy a
good/services becomes lesser $1 can buy 5 sweet, but
when inflation increases, $1 can only buy 4 sweet.
Spends slow more of a balance between economys production
and spending levels demand for imported goods from
overseas decrease, bringing about an improvement in the balance
of payments
(improve balance of payments)

increase short term interest rates increase in the flow of

investment funds into the country increase in demand for the
local currency in the foreign exchange market price of the
currency would be bid up and appreciate ()
Open Market Operation
-

1) direct buying and selling of government securities

2) repurchase agreements (repos)
3) foreign currency swaps
-

these transaction affect the money supply and level of

liquidity in the financial system.