Chapter 13 - Money and Interest Rates

What are money markets

• A money market is a part of the financial market where short-term borrowing and lending of funds occurs

• Functions similarly to any market:

  -Borrowers = consumers (demand funds)

  -Lenders = producers (supply funds)

  -Price of money = interest rate

Key characteristics of money markets

Element:	Description:

Element:	Description:
Demand	Borrowers (households, businesses, governments) seeking funds
Supply	Lenders (banks, investors, financial institutions) providing funds
Price	Interest rate - the cost of borrowing or return on lending funds

Role of the RBA in money markets

Heavily influences interest rates via monetary policy

Unlike regular markets, money market prices are regulated to meet macro-economic objectives:

Inflation control

Employment support

Economic growth

Money is essential for

• Transactions: buying goods and services

• Saving: For future consumption or retirement

• Investment: in businesses, property, shares, etc.

A solid understanding of how money markets explains

• Interest rate movements

• Access to credit

• Business investment decisions

• Government monetary policy impacts

Individuals borrow for personal consumption or asset purchases. What types of loans do they have?

Type of Loan:	Purpose:	Secured?	Interest Rate

Type of Loan:	Purpose:	Secured?	Interest Rate
Mortgage	Buying a house	Secured by property	Lower
Personal loan	Cars travel, education	Often unsecured	Higher
Credit card	Short-term spending	Unsecured	Very high

What are security matters

Loans with collateral (like a house) carry less risk for the lender, so they offer lower interest rates

Unsecured loans are

riskier for lenders, so they attract higher interest rates

Businesses are the biggest borrowers in the economy and borrow to:

• Expand production

• Fund R&D for projects

• Manage cash flow fluctuations

What are the two methods for banks to borrow funds

Method:	Description:

Method:	Description:
Direct	Issues shares (equity) or bonds (debt)
Indirect	Take out loans from banks

What is cash flow borrowing

Eg. farms may only earn income at harvest but need funds all year-round so they overdraft or take short-term loans

Why do governments borrow

• Stimulate the economy in downturns (e.g. JobKeeper in 2020)

• Cover budget deficits when spending > revenue

• Fund infrastructure (eg. transport, energy grids)

- Long-term projects are often paid off over time, aligning cost with future benefits

Liquidity

How easily an asset can be converted into cash

What is the liquidity of:

• Money (cash, bank deposits)

• Financial assets (shares, bonds)

Most liquid, but earns no return

Less liquid, but can earn returns (dividends, interest)

Motives for holding liquid funds

Motives:	Descriptions:

Motives:	Descriptions:
Transactions Motive	Need liquid funds for daily purchases
Precautionary Motive	Need quick access to funds for unexpected emergencies (eg. illness, job loss)
Speculative Motive	People hold money if they expect asset prices to fall, avoiding potential capital losses

Impact of technology on liquidity demand

Modern financial systems and technologies (online banking, contactless payments) have led to a reeduced need to hold cash

Main reason for rising household debt

1. Long period of low interest rates - larger loans more affordable

2. Financial deregulation and innovation - easier access to credit

3. Rising house prices - higher mortgage borrowing

4. Rising income and low inflation - greater borrowing capacity

Household debt not considered an economic threat due to:

• Built-up pandemic savings

• Employment growth

• Better lending standards

Businesses borrow to

• Fund investment and expansion

• Smooth cash flow (especially seasonal industries like agriculture)

Business borrowing increases when

• Interest rates are low

• Economic outlook is strong

Financial innovations reshaping finance

• BNPL platforms (eg. Afterpay)

• Online stockbrokers (eg. eToro, CommSec)

• Cryptocurrencies (eg. Bitcoin)

Challenges of digital currencies and financial innovations

• Volatility and limited acceptance prevent cryptos from replacing money

• Central banks (including RBA) are exploring CBDC’s (central bank digital currencies) as a more stable digital alternative

Lenders - the supply of funds

Lender:	Description:
Individuals
Businesses
Governments
International Sector

Lender:	Description:
Individuals	Lend by putting savings into banks or buying financial assets like shares/property. They receive interest or dividends as a return
Businesses	Lend surplus funds by depositing in banks if expansion isn’t immediately needed. They assess whether interest returns outweigh investment returns
Governments	Can act as lenders if running a budget surplus - they may pay off debt or lend via the financial sector
International Sector	Foreign investors/lenders supply funds to Australian borrowers. Important due to Australia’s low savings rate

How does lending work

Individuals place savings in a bank ($100)

Bank lends out most of that money ($90) to borrowers, keeping some as reserves

The individual earns interest ($2) and the borrower pays back the loan with interest

This creates the supply of funds in financial markets

Lending is the flip side of borrowing

One person’s savings = another person’s loan

Australia historically has low national savings so

it borrows from international lenders

The GFC showed risks of relying on overseas funds:

• Credit shortage globally

• Australian banks had to raise interest rates beyond RBA increases to attract funds

• The government guaranteed overseas borrowings by banks to reassure international lenders

The four characteristics of money

Characteristic:	Explanation:

Characteristic:	Explanation:
Medium of exchange	Money is used to buy goods/services instead of bartering
Measure of value	Money helps compare the value of different items
Store of Value	Money retains its value over time and can be saved
Method of deferred payment	Money enables borrowing and lending, where payment can be made in the future

Money and currency should not be associated with each other, but

• Currency is only <5% of the total money supp

• Broader definitions of money that include bank deposits

Measures of the money supply

Measure:	Includes:	Liquidity:

Measure:	Includes:	Liquidity:
Currency	Physical money held by public	Most liquid
M1	Currency + transaction deposits (eg. everyday bank accounts)	Highly liquid
M3	M1 + non-transaction deposits (eg. term deposits)	Least liquid (wildest measure)
Broad Money	M3 + NBFI deposits - NBFI deposists in banks	Least liquid (wildest measure)

Credit is not money, but closely related

Refers to

Loans given by banks/lenders to households and businesses

Borrowers get money upfront

lenders receive a credit asset (right to be repaid + interest)

What is money supply

All funds available in the economy that act as money (meet all 4 characteristics)

What is liquidity

How easily something can be converted into money

What is an interest rate

The price of borrowing money, expressed as a percentage of the total borrowed

It brings about equilibrium in financial markets

• Borrowers demand more funds when interest rates are low

• Lenders supply more funds when interest rates are high

How interest rates work in financial markets

Group:	Role:

Group:	Role:
Borrowers	Demand funds (eg. for mortgages, business investment)
Lenders	Supply funds (eg. through savings, deposits)

The interest rate balances

supply and demand of funds

represented in a demand-supply graph: higher reates = more supply, less demand

How financial institutions operate

• Banks borrow from savers - pay them interest = borrowing rate

• Banks lend to customers - change interest = lending rate

• The interest rate differential (lending rate - borrowing rate) = net interest margin (bank profit)

Short-term vs long-term interest rates

Type:	Maturity:	Example:	Characteristics:

Type:	Maturity:	Example:	Characteristics:
Short-term	<1 year	Treasury Notes	Lower risk, more liquid
Long-term	>1 year	Bonds, mortgages	Higher risk & return, less liquid

Longer-term loans often have higher rates to

compensate for risk and illiquidity

Factors influencing interest rates

Factor:	Effect on Interest Rates:

Factor:	Effect on Interest Rates:
Investment demand (capital goods)	↑ investment → ↑ demand for funds → ↑ rates
Level of savings	↑ savings → ↑ supply of funds → ↓ rates
Preference for liquidity	↑ preference for cash → ↓ supply of funds → ↑ rates
Inflation expectations	↑ expected inflation → lenders want ↑ nominal rates
Government budget balance	Budget deficit → ↑ govt borrowing → ↑ rates
International interest rates	Higher overseas rates → funds flow out → ↓ supply → ↑ local rates
Reserve Bank policy	RBA adjusts cash rate to influence overall interest rates

What does nominal interest rate mean

Actual rate charged/paid, not adjusted for inflation

What does real interest rate mean

Nominal rate minus inflation - reflects true purchasing power of returns

What does equilibrium interest rate mean

Rate at which supply = demand for loanable funds

What does interest rate differential mean

Gap between lending and borrowing rates at financial institutions

What is the cash rate

The interest rate on overnight loans between banks in the overnight money market

Set by the RBA as part of its monetary policy

Affects all other interest rates in the economy (mortgages, business loans)

Why is the cash rate important

Affects cost of borrowing and return on saving

Used by the RBA to manage economic activity

↑ Cash rate → ↑ borrowing costs

↓ spending/investment → tightening

↓ Cash rate → ↓ borrowing costs

↑ spending/investment → loosening

How the RBA influences the cash rate

1. Exchange Settlement (ES) Accounts

• Banks use ES accounts at the RBA to settle payments between each other

• Banks with surplus ES funds can lend overnight to banks with shortages

2. Policy Interest Rate Corridor

• Sets a ‘floor’ and ‘ceiling’ for the cash rate:

- Floor: RBA deposit rate = 0.25% below target - prevents cash rate falling too low

- Ceiling: RBA lending rate = 0.25% above target - prevents cash rate rising too high

- Ensures the actual cash rate stays close to target

3. Open Market Operations (OMO)

• RBA buys/sells financial securities to control supply of ES funds

- Buys securities → injects ES funds → ↓ cash rate

- Sells securities → withdraws ES funds → ↑ cash rate

Impact of cash rate on the economy

Cash Rate ↓ (Loosening)	Cash Rate ↑ (Tightening)

Cash Rate ↓ (Loosening)	Cash Rate ↑ (Tightening)
↓ borrowing costs	↑ borrowing costs
↑ consumption/investment	↓ consumption/investment
↑ economic activity	↓ economic activity

Mechanism of monetary policy

Unconventional monetary policy

When cash rate was near zero, the RBA used unconventional tools:

Tool:	Purpose:

Tool:	Purpose:
Asset Purchases (QE)	RBA bought gov. bonds → ↑ ES funds → ↓ long-term interest rates
Forward Guidance	RBA gave forecasts to shape expectations of future cash rates
Term Funding Facility (TFF)	Cheap loans to banks to boost lending to households and SMEs
Narrowed Policy Corridor	Floor set only 0.10% below target (not 0.25%) → allowed further stimulus

What is monetary policy

RBA’s use of interest rates to control economic activity

What is policy rate corridor

• Floor and ceiling around the cash rate target

What are ES Accounts

Where banks settle interbank transactions

What are open market operations

RBA buying/selling securities to adjust ES funds

What is quantative easing (QE)

RBA buys bonds to lower long-term interest rates