ECON204 Lecture Notes - Lecture 9: Nominal Interest Rate, Real Interest Rate, Open Market Operation
17 May 2018
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Topic 9
Interest Rates:
Or approximately (when nominal interest rate and expected inflation are not too large)
Australia:
The nominal interest rate is the ten year Treasury bond rate at the end of the year.
While the nominal interest rate has declined considerably since 1980, (2.3% 2016), the real interest
rate was higher in 2011 (1.0% 2016)
With the nominal rate so low, the RBA cannot decrease it much more --- Australia is not far from the
liquidity trap.
If unemployment rose a lot, bringing deflation, the real rate may become too high – as it did in the
Great Depression of the 1930s.
Inflation Targeting and the IS-LM Model
• The real interest rate affected investment in
the IS relation. Firms want to know how much they
will gave to repay in terms of goods. Investment
spending, and this the demand for goods, depends
on the real interest rate
• The nominal interest rate, the interest rate
affected directly by monetary policy, affects choice
between money and bonds in the LM relation.
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Now we also incorporate the monetary policy rule:
The effects of monetary policy on output therefore depends on how movements in the nominal
interest rate translate into movements in the real interest rate.
Expansionary Monetary Policy
For fixed P, M, G, T and :
• The IS curve is still downward sloping: the nominal interest rate the real interest rate move
together. A decrease in the nominal interest rate leads to an equal decrease in the real
interest rate, leading to an increase in spending and in output.
• The LM curve is upward sloping: an increase in output, leads to an increase in the demand
for money, requires an increase in the nominal interest rate. i.e. that the central bank
increases money supply with open market operations.
In the short run, with expansionary monetary policy:
• Real and nominal interest rates fall
• The LM curve shifts right as M/P increases.
• The IS curve does not shift in the short run.
• Output rises.
• P, π, ad πe do’t hage.
In the long run, with expansionary monetary policy:
• Nominal interest rate and Inflation rise.
• The IS curve shifts right due to higher inflation
• the LM curve shifts back left due to higher interest rates.
• Therefore, the real interest rate, and output returns to its natural level.
Raising Capital
Firms raise funds in two ways:
• Through debt finance—bonds and loans; and
• Through equity finance, through issues of stocks—or shares.
Bods pay pedeteied aouts; stoks pay divideds fo the fi’s pofits.
Bonds
Bonds differ by default risk and maturity. Bonds of different maturities each have a price and an
associated interest rate called the yield to maturity, which is always expressed in annualised form.
The relation between maturity and yield on a particular day is called the yield curve, or the term
structure of interest rates.
The present value of a perpetuity:
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To determine the yield curve and the relation between short term interest rates and long term
interest rates, we proceed in 2 steps:
1. Bond prices for bonds of different maturities.
equating the expected one year return,
we find that
2. Go from bond prices to bond yields;
yields contain the same information about future expected interest rate as bond prices
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If we only consider this year interest rate, and the expected interest rate next year:
When the yield curve is
• upward sloping, long term interest rates are higher than short term interest rates.
• downward sloping, long term interest rates are lower than short term interest rates.
Remarks:
• Long-term interest rates reflect current & future expected short-term interest rates.
• Short-term rates will have more variability than long-term ones, because a change in the
current short rate may be reversed in the future
The Stock Market
The stock market may affect real investment through collateral effects – it may affect wealth of
households, and therefore consumption. Therefore, IS curve and AD curve may shift right when the
stock market is in a bull phase, or left when it is in a bear phase.
Major movements in stock prices cannot be predicted. But, we can look back and explain how macro
news has affected the market.
The impact of a monetary expansion depends on whether financial markets anticipated it.
• If fully anticipated, stock markets will not react now.
• If not anticipated, stock prices will rise because of higher expected dividends and lower
interest rate
The impact of increased consumer spending is ambiguous:
• Higher output implies higher profits, and so higher stock rices
• Higher interest rates imply lower stock prices.
The effect that dominates depends on the stegth of the etal ak’s espose.
Bubbles
• Asset prices affect economic activity, by influencing consumption and investment spending.
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Or approximately (when nominal interest rate and expected inflation are not too large) The nominal interest rate is the ten year treasury bond rate at the end of the year. While the nominal interest rate has declined considerably since 1980, (2. 3% 2016), the real interest rate was higher in 2011 (1. 0% 2016) With the nominal rate so low, the rba cannot decrease it much more --- australia is not far from the liquidity trap. If unemployment rose a lot, bringing deflation, the real rate may become too high as it did in the. The real interest rate affected investment in the is relation. Firms want to know how much they will gave to repay in terms of goods. Investment spending, and this the demand for goods, depends on the real interest rate. The nominal interest rate, the interest rate affected directly by monetary policy, affects choice between money and bonds in the lm relation. (cid:1839)=(cid:1838)(cid:4666)(cid:4667)
