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Chapter+05+Answers+to+end-of-chapter+questions - CHAPTER 5...

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CHAPTER 5 INTEREST RATE RISK: THE MATURITY MODEL Chapter outline The Reserve Bank of Australia and Interest Rate Risk The Maturity Model The Maturity model: An Example The Maturity Model with a Portfolio of Assets and Liabilities Maturity Matching Does Not Always Eliminate Interest Rate Risk Exposure Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 1
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Answers to end-of-chapter questions QUESTIONS AND PROBLEMS 1. The Reserve Bank utilises monetary policy to affect the level of economic activity. Assume that the economy is in a recession and the Reserve Bank has decided to use monetary policy to increase the level of economic activity. What are the two alternative approaches available to the Reserve Bank to accomplish this monetary policy goal? Compare the two approaches to monetary policy, concentrating on their relative impacts on the volatility of interest rates. Are these two approaches to monetary policy mutually exclusive? Why or why not? The RBA will pursue an easing of monetary policy to raise the level of economic activity. There are two alternative approaches to accomplish this goal. First, the RBA can undertake transactions (open market operations) to reduce the level of interest rates. Interest rates are lowered to encourage spending and investment, thereby raising the level of economic activity. The RBA directly impacts on the level of short-term interest rates through its open market operations. It injects funds into the banking system through the purchase of short dated securities, which lowers interest rates. Typically the RBA will set an interest rate band for short term rates and conduct its monetary policy to maintain rates within that band. Since all interest rates are related, the level of all rates will be reduced, thereby stimulating the economy. Alternatively (or concurrently), the RBA can undertake transactions to raise the supply of money in circulation. This will encourage additional spending and investment and in the process raise the level of economic activity. The RBA can change the level of any reserve requirements held with the RBA. This will put more money into circulation, which will stimulate economic activity. If this policy were pursued, the RBA would set a target of the quantity of money it would like to see in circulation (taking into account the multiplier effect). This would leave the level of interest rates free to float unhindered as the supply of money increases. This is an approach no longer used by the RBA as it was found to be less effective in controlling the supply of money in the economy. With the first alternative the level of interest rates is actively administered by the RBA and is maintained within a relatively narrow band, resulting in lower volatility than under the second alternative. If the alternative strategy is employed, when money supply aggregates are targeted by the RBA, interest rates fluctuate widely according to fluctuations in supply and demand.
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