Interest Rate Theories

Interest Rate Theories

Introduction

• This module and the next will explore the theories behind the term structure of interest rates.
• The goal is to understand why the yield curve has its specific shape.

Determinants of Interest Rates in Australia

• Interest rates in Australia are set by the Reserve Bank of Australia (RBA).
• The RBA uses the cash rate to implement monetary policy.

The Cash Rate

• The cash rate is the interest rate charged on overnight loans between financial institutions.
• It is a very short-term interest rate.

Monetary Policy

• Monetary policy is the government's main tool for influencing key economic factors.
• These factors include:
  • Economic growth
  • Inflation
  • Unemployment

Impact of Interest Rates

• Low interest rates:
  • Encourage borrowing for consumption and investment.
  • Increase economic growth.
  • Decrease unemployment.
  • Potentially increase inflation.
• High interest rates:
  • Slow down economic growth.
  • Decrease inflation.
  • May result in higher unemployment.

RBA's Objective

• The RBA aims to flatten out swings in economic growth.
• The goal is to avoid recessions.
• Australia has not had a recession since 1991.