Pure Expectations Theory

RBA and Open Market Operations

  • The RBA uses open market operations to target the cash rate.
  • It buys and sells bonds to maintain the cash rate at its target.
  • Market forces cause changes in short-term rates to flow through to long-term interest rates.

Theories Behind the Term Structure of Interest Rates

  • This module discusses two theories behind the term structure of interest rates and the shape of the yield curve.

Pure Expectations Theory

  • One of the theories is the pure expectations theory.
Assumptions
  • Indifference between Maturities: Borrowers and lenders are indifferent between securities with different maturities and will switch between short, medium, and long-term securities to get the best value.
    • Best value means low-interest rates for borrowers and high-interest rates for lenders.
  • Perfect Capital Market: The capital market is perfect, meaning there are no transaction costs.
    • No transaction costs allow market participants to move between different maturities without incurring costs.
    • While real-world transaction costs exist, they don't undermine the theory's main conclusion.
    • Assumptions simplify understanding of the theory.
Logical Consequences of the Assumptions
  • Scenario: Short-term and long-term rates are equal (e.g., 5%), but short-term rates are expected to increase in the future (e.g., 6%).
  • In this case, investors would prefer a series of successive short-term investments to capitalize on higher future rates.
  • If many investors prefer short-term investments, long-term interest rates will increase to attract investors.
  • Long-term rates will increase until they are high enough to attract investors, at which point short-term investments do not provide higher returns, after all the risks are accounted for.
  • In equilibrium, the return from a series of short-term investments equals the return from one long-term investment.
Prediction
  • Long-term rates are determined by investor expectations regarding future short-term rates.
  • Investors switch between short, medium, and long-term securities, and market forces ensure there is no easy money to be made.
  • Long-term rates adjust to reflect expected future short-term rates.
  • Specifically, long term rates will be the geometric average of expected future short term rates.
  • Long-term result = Expected result from investing in a series of short-term securities.