A general principle is that bond prices and interest

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A general principle is that bond prices and interest rates are inversely related.
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Why are interest rates and bond prices inversely related? If the interest rate is below the equilibrium market price for money, the demand for money is greater than the supply. To increase money holdings, the public will start to sell off their bonds. An increase in the supply of bonds leads to a reduction in their price, which is equivalent to an increase in interest rates. At higher interest rates, the demand for money will decline, until equilibrium is reached where the money demand is equal to the amount of money available at that interest rate.
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Figure 8.1 The market for 90-day bills
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Figure 8.2 The effect of an increase in the cash rate on the 90-day bill market
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Figure 8.3 The demand and supply of base money i Base Money = currency + deposits of banks with the RBA (this includes exchange settlement accounts)
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The Reserve Bank conducts monetary policy by setting the overnight cash rate to a target and allowing all the other interest rates in the economy to adjust. Assume the Reserve Bank achieved a target cash rate and a specific target money supply: If demand for money increased, the demand for money function would shift to the right. If the Reserve Bank left the money supply unchanged, people would start to sell bonds to do so. The price of bonds would decrease, which would increase the interest rate.
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Figure 8.4 A change in the target cash interest rate Increase in target rate lead to increase in interest rate on ESA’s, increases demand and increases target rate. Increase of demand in ESA’s decreases funds loaned in cash market , therefore increases cash rate
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Figure 8.4 A change in the target cash interest rate S 1 To maintain existing cash rate RBA uses OMO to buy govt securities to increase money supply
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RBA target nominal interest rate ( i ) the cash rate - through OMO Yet decisions to save and invest depend on the real interest rate ( r ) Recall , r = i (where r = real interest rate, i = nominal interest rate = inflation rate) since inflation rate adjusts reasonably slowly, RBA can change the real interest rate ( r ) in short run by changing the nominal interest rate ( i ) In long run r depends on the supply and demand for savings - and interest rate differential (as compared to overseas interest rates) 55
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Current monetary policy works by changing the cash rate The RBA sells/buys government securities to achieve targeted cash rate The banks buy/sell government securities to accommodate the RBA and reserves change As bank reserves fall/rise, banks reduce/increase loans The increase/reduction in the cash rate feeds through to other short term interest rates Impacts general level of spending and the broader economy 56
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57 cash rate other rates real interest rate spending (I, C) exchange rate (NX) output employment inflationary pressures
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58 cash rate other rates real interest rate spending ( I, C) depreciation $A ( NX) output employment inflationary pressures
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