Major Determinants of Interest Rates Essay

Major Determinants of Interest Rates Inflation Inflation is a factor that decisively affects the nature or outcome of interest rates. “Inflation is an increase in prices of goods and services over time”(Financial Institutions, Instruments and Markets, 2012). Inflation is the natural byproduct of a robust, growing economy. No inflation, or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.

A standard explanation for the cause of inflation is “too much money chasing too few goods” This is also called the demand-pull theory.

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For several possible reasons, more money is being spent than normal. This could be because interest rates are low and people are borrowing more. There’s not enough supply to keep up with the rising demand for homes, cars etc. Manufacturers are producing goods at a slower rate than people are demanding goods. When supply is less than demand, prices go up. How Stuff Works, 2012) Different types of interest rate are linked and influence each others, for example if unemployment rates were relatively high the RBA would lower interest rates so that the functioning of the financial markets remain positive and Australia would continue a healthy economic status.

The inflation rate in Australia was recorded at 1. 20 percent in the second quarter of 2012. Historically, from 1973 until 2012, Australia Inflation Rate averaged 5. 83 Percent reaching an all time high of 17. 60 Percent in March of 1975 and a record low of -0. 0 Percent in September of 1997. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy. (Trading Economics, 2012) Inflation target is a tool to guide monetary policy expressed as a preferred range or figure for the rate of increase in prices over a period. In Australia, the inflation target is between 2 and 3 per cent per annum on average over the course of the business cycle. (RBA, 2012)

With all this information given, with the current inflation rate sitting at 1. per cent, down from 1. 6 per cent the previous quarter and the RBAs target being at around 2-3 per cent, we can determine that the Australian economy is in prime position for our engineering firm to invest as at this point the economy in our eyes looks confident and optimistic to invest as there could be an economic boom. During low inflation the quantity of earnings is high in firms and = therefore the investments in a company also increase. Money Supply Money Supply is another factor that certainly affects the nature or outcome of interest rates. Money supply is the entire stock of currency and other liquid instruments in a country’s economy as of a particular time” (Investopedia, 2012). The money supply in easier terms is any current cash, coins and balances held in checking and savings accounts that the public hold in Australia. “Economists analyse the money supply and develop policies revolving around it through controlling interest rates” (Investopedia, 2012). Money supply data is collected, recorded and published periodically in Australia after the money supply increases or decreases in the economy.

Public and private sector analysis is performed because of the money supply’s possible impacts on interest rates, price level, inflation and the business cycle. From 1 July 1998, a new system came into place for the financial regulatory framework in response to the recommendations of the Financial System Inquiry (Wallis Committee). Under these arrangements, the Reserve Bank of Australia has stronger regulatory powers in the payments system in accordance with the Payments Systems (Regulations) Act 1998 (Cwlth) (ABS, 2012). The money supply is important to economists trying to understand how policies will affect interest rates and growth.

Monetary policy is the process by which the Reserve Bank of Australia (RBA) manages the money supply to achieve specific goals. These specific goals can be seen on the Reserve Banks website stating the objective of monetary policy: * the stability of the currency of Australia; * the maintenance of full employment in Australia; and * the economic prosperity and welfare of the people of Australia. These objectives are put in place to try and obtain, develop and encourage strong sustainable growth in Australia’s economy. As mentioned above, Australia’s target for inflation is around 2-3 per cent per annum.

In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy. The current broad money supply in Australia economy at this point in time is $1496. 1 billion dollars compared to 10 years ago which the broad money supply was $594. 8 billion. The broad money supply has nearly tripled in the past decade (RBA Statistics, 2012). With the increasing money supply in the Australian economy it has a powerful effect on all economic activity as money is used in virtually all transactions.

An increase in the supply of money works both through lowering interest rates which spurs investments and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labour and raises the demand for capital goods (Econlib, 2012). Exchange Rates Exchange rates are another factor that decisively impacts the nature or outcome of interest rates. An exchange rate is the price of one country’s currency expressed in another country’s currency. In other words, the rate at which one currency can be exchanged for another” (Investopedia, 2012). Exchange rates play a fundamental role in Australia’s level of trade. Exchange rates are among the most watched, analysed and governmentally manipulated economic measures, but exchange rates matter on a smaller scale as well because an example being they impact the real return of an investor’s portfolio (Investopedia, 2012).

Exchange rates and interest rates, as well as inflation, are all interconnected. “Higher interest rates offer lenders, such as Australia’s four big banks; ANZ, NAB, Commonwealth and Westpac, a higher return compared to other countries… however lower interest rates tend to decrease exchange rates” (Investopedia, 2012). Australia’s exchange rates are published daily except on public and bank holidays by the Reserve Bank of Australia (RBA). The table below shows the exchange rates for the 13th, 14th and 17th of September 2012 (RBA website).

Units of foreign currency per A$ (Reserve Bank of Australia)| | 13th September 2012| 14th September 2012| 17th September 2012| United States Dollar| 1. 0471| 1. 0579| 1. 0534| European Euro| 0. 8102| 0. 8115| 0. 8022| Chinese Renminbi| 6. 6291| 6. 6835| 6. 6530| Japanese Yen| 81. 37| 82. 06| 82. 47| United Kingdom Pound| 0. 6498| 0. 6531| 0. 6493| Indian Rupee| 58. 07| 57. 85| 56. 75| Thailand Baht| 32. 48| 32. 55| 32. 43| | ‘Interest rates can also have economic effects, which influence currency exchange.

Following the idea of supply and demand, speculators favour the currency of economies that are expanding, creating a virtual cycle of appreciation. An economy who’s GDP is rising faster than its monetary base is by default increasing the value of its currency, and this will likely be reflected in currency exchanges’ (E How, 2012) With this information given an example of how interest rates can have economic affects which will influence currency exchange is in the United States, where interest rate have averaged 6. 1 percent however as of September 17th 2012 the United States interest rate is currently 0. 25 percent. If the price of the US dollars drops in value from $2 to $1, United States exports in Australia will become much cheaper relative to the home-produced goods on offer. The demand for these US exports will rise in Australia, and the demand for USD to buy these exports will also rise as a result. So at lower prices (or exchange rates) more USD will be demanded. There are other determinants of interest rates; Unemployment Rate

The unemployment rate is the percentage of total workforce who are unemployed and are looking for a paid job. Unemployment rate is one of the most closely watched statistics because a rising rate is seen as a sign of weakening economy that may call for cut in interest rate. A falling rate, similarly, indicates a growing economy which is usually accompanied by higher inflation rate and may call for increase in interest rates (Business Dictionary, 2012). If the unemployment rate is relatively high, then interest rates may decrease to account for those who cannot afford to pay interest on things like mortgages.

Consumer Price Index Consumer price index is a measure of changes in the purchasing-power of a currency and the rate of inflation. The consumer price index expresses the current prices of a basket of goods and services in terms of the prices during the same period in a previous year, to show effect of inflation on purchasing power. It is one of the best known lagging indicators (Business Dictionary, 2012). The consumer price index is also a determinant of interest rates.

CPI shows the effects of inflation, which previously said before ‘Inflation target is a tool to guide monetary policy expressed as a preferred range or figure for the rate of increase in prices over a period’, so according to the inflation rate the RBA may increase or decrease the interest rates so the Australian economy is a growing and healthy economy. References: Christopher Viney and Peter Phillips, Financial Institutions Instruments and Markets (McGraw-Hill Australia Pty Ltd, 7th Edition) pg 8 How Stuff Works 2012, Money, Interest Rates, viewed 18th September 2012 <http://money. howstuffworks. om/interest-rate4. htm> Trading Economics 2012, Australia, Inflation, viewed 18th September 2012 <http://www. tradingeconomics. com/australia/inflation-cpi> Reserve Bank of Australia 2012, Definition, Inflation, viewed 18th September 2012 <http://search. rba. gov. au/search? q=inflation&btnG. x=0&btnG. y=0&entqr=0&sort=date%3AD%3AL%3Ad1&output=xml_no_dtd&client=newRBA&ud=1&oe=UTF-8&ie=UTF-8&proxystylesheet=newRBA&proxyreload=yes&site=RBA-all> Economics Help 2012, Macro Economics, Inflation, Low Inflation, viewed 18th September 2012 <http://www. conomicshelp. org/macroeconomics/inflation/low_inflation. html> Economy Watch 2012, Inflation, viewed 18th September 2012 <http://www. economywatch. com/inflation/low. html> Investopedia 2012, Money Supply, viewed 18th September 2012 <http://www. investopedia. com/terms/m/moneysupply. asp#axzz26OcDdsSD> Australian Bureau of Statistics 2012, Money Payment System, viewed 18th September 2012 <http://www. abs. gov. au/ausstats/[email protected] nsf/Lookup/by%20Subject/1301. 0~20

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