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.