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AN INTRODUCTION TO THE INTEREST RATE DETERMINATION AND FORECASTING Macroeconomic context of interest rate determination By understanding what motivates a central bank in its implementation of interest rate policy - Financial market participants can anticipate changes in a government’s interest rate policy - Lenders and borrowers can make better informed decisions Central banks may increase interest rates if there is - Inflation above target range - Excessive growth in GDP - A large deficit in the balance of payments - Rapid growth in credit and debt levels - Excessive “downward” pressure on FX markets The tightening of the monetary policy (increase in interest rates) leads to - eventually increase in long term rates - slow consumer spending (reduce inflation and demand for imports) - decrease the size of the current account - possibly attract foreign investment causing domestic currency to appreciate There are three effects of changes in interest rates: Liquidity effect The affect of the RBA’s market operations on the money supply and system liquidity i.e. RBA increases rates by tightening the monetary policy, selling of CGS. Income effect This is the flow on effect from the initial liquidity impact on interest rates. The increased interest rates reduce spending in the economy which results in lower incomes in all sectors of the economy: the household, business and the government sector. Inflation effect As the rate of growth in economic activity slows, the demand for loans also slows thus this eases the rate of inflation Forecasting interest rates requires “how” and “to what extent”: - the central bank will response to the current and prospective rates of growth in the economy, the rate of inflation and the balance of payments, all of which will determine the liquidity effect on interest rates -The demand for money will adjust to changes in the level of economic activity that is the income effect on rates. -The rate of inflation will change, resulting in the inflation effect on interest rates. Central bank research indicates that it may take up to 2 years for monetary policy changes to fully work through an economy. Economic indicates are thus used to provide some insight into possible future economic growth. In the absence of a single reliable measure, it is necessary to look at a range of indicators to understand the current state of the economy. 1. Leading Indicators Economic data in these changes before changes in the trend in the level of economic activity occurs. They anticipate changes in the business cycle. 2. Coincident Indicators These provide same time tracking of the level of economic activity.
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3. Lagging Indicators Economic variables that change after a change in the business cycle. They are used to confirm the movement in economic growth. Indicators of economic activity include: Gross domestic product, gross national income, balance of
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This note was uploaded on 04/04/2012 for the course FINS 1612 taught by Professor Nice during the Three '10 term at University of New South Wales.

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