Chapter 13 End-Chapter Essay Questions Solutions

Chapter 13 End-chapter essay questions solutions
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1 Compare and contrast the nature and implementation of monetary policy vis-a-vis
fiscal policy as the two primary tools of economic management. Outline the recent
trends that characterise the implementation of each policy type. (LO 13.1)
ANSWER
Monetary policy is principally directed towards containing inflation within a target

range of 2 to 3 per cent over the business cycle. It is implemented by the central bank.
In directing its policy decisions to achieve this objective, the central bank will consider:
 the underlying rate of inflation over the business cycle

 the rate of employment/unemployment/employment growth
 the stability of the currency—in particular relative to major trading partners
 the welfare of the people
 the current economic environment/business cycle
 current monetary policy settings
 the direction of economic growth
 the impact on past monetary policy settings on current and future economic
growth
 time delays between a change in monetary policy settings and a change in
economic growth
 economic fundamentals in major trading partner countries
 forecast changes in international economic growth
 a wide range of economic indicators, such as housing loan approvals.
IRM to accompany Viney & Phillips Financial Institutions, Instruments and Markets, 9th edition
© 2019 McGraw-Hill Education (Australia)
 Fiscal policy is the government’s decisions regarding income/spending. It is
implemented by the government through changes in such things as its borrowing,
spending and taxation rates.
 Since the GFC, central banks have largely been operating an ‘easy’ monetary
policy designed to stimulate the economy. As the GFC recedes into the past,
central banks have gradually tightened monetary policy. Similarly, governments
ran large deficits and increased spending to avoid or minimise recessions.
Government deficits are gradually being reduced.
2 The macroeconomic context of interest rate determination attempts to explain the

interactions of a change in monetary policy settings with changes in interest rates. The
macroeconomic context of interest rate determination identifies three distinct effects of
a change in monetary policy. (LO 13.1)
a. List the three effects

ANSWER
 Liquidity effect
 Income effect
 Inflation effect
Section 13.1
b. If the central bank tightens its monetary policy settings, describe the expected
interactions that should occur based on the three effects identified in part (a).
ANSWER
 In order to tighten monetary policy the Reserve Bank will implement a strategy
of selling securities to the financial market; that is, it sells government paper and
therefore receives payment that reduces the amount of funds available within the
financial system.
 This monetary policy action of the central bank will impact upon interest rates,
particularly the overnight cash rate.
(i) Liquidity effect:
 The central bank’s action of selling government securities in order to affect the
money supply will directly affect the level of liquidity in the financial system.
 If the central bank sells securities into the financial system, then there will be less
cash in the system as investors pay cash to buy the securities thus reducing
liquidity in the financial system.
 By tightening of liquidity, with less cash available for lending, interest rates will
rise.
(ii) Income effect:
 The income effect refers to the flow-on effect from the initial liquidity impact on
interest rates.
 In the example, the central bank has tightened liquidity and increased interest
rates. Increased interest rates will typically reduce the levels of spending in the
economy.
 Reduced levels of spending will result in lower incomes in all sectors of the
economy: the household sector, the business sector and the government sector.
 This occurs as employment growth slows, demand for goods and services eases
and taxation revenues to government decline.
 As the rate of growth in economic activity slows, the demand for loans also
slows.
 The slowing in the demand for funds eventually will result in an easing in
interest rates.
(iii) Inflation effect:
 In so far as the economy was previously experiencing inflationary pressures due

to high levels of demand, now the slowing of the pace of economic activity will
cause the rate of inflation to ease.
 This easing allows rates of interest to ease as well.
 The nominal rate of interest is said to comprise two components, being the real
rate of return plus compensation for the expected rate of inflation.
 If the rate of inflation is expected to fall, then it is expected that the nominal or
market interest rates should fall.
Section 13.1
3 Market participants, including financial institutions, funds managers and

corporations, must understand monetary policy setting impacts on economic activity
and the business cycle. A central bank will typically implement monetary policy
settings in order to achieve certain economic outcomes over a business cycle. In order
to forecast future economic conditions and business activity, business managers
therefore need to understand the business cycle. (LO 13.1)
a. Briefly describe the principal monetary policy objective of the Reserve Bank of
Australia.
ANSWER
 The principal objective of current monetary policy is to implement monetary

policy initiatives that contain inflation within a target range of 2 to 3 per cent
over the business cycle.
Section 13.1
b. Draw a diagram and explain the structure of a business cycle over time.
ANSWER
 The business cycle is a measure of changes in the level of economic activity in an

economy over time.
 It tends to move in changing cycles of peaks and troughs.
 Business cycle peak—the highest level of economic activity during a cycle.
 Business cycle trough—the lowest level of economic activity during a cycle
Section 13.1
c. Discuss and give examples of different economic indicators that may give an
insight into the future stages of a business cycle.
ANSWER
 Economic indicators are constructed from a set of historic data that provide some
insight into possible future economic growth.
 Leading indicators—economic variables that change before there is a change in
the business cycle.
 Coincident indicators—economic variables that change at the same time as the
business cycle changes.
 Lagging indicators—economic variables that change after there is a change in the
business cycle.
There is a wide range of economic indicators. Governments, central banks, corporations and
analysts will select a number of indicators that best inform them, including:
 the rate of inflation over the business cycle
 the rate of growth in gross domestic product
 the balance of payments
 credit growth and associated debt levels
 the exchange rate relative to major trading partner currencies
 the rate of unemployment, job vacancies and ratio of full-time and part-time
employment
 the balance of payments, imports and exports growth
 finance for housing, residential and non-residential building approvals
 economic activity and capacity utilisation
 wages growth and overtime worked
 retail sales
 share price movements.
Section 13.1
4 At a recent financial markets seminar, a participant asked the guest speaker to explain
the loanable funds approach when forecasting interest rates. (LO 13.2)
a. Describe the basic concept of the loanable funds approach to interest rate
determination.
ANSWER
 The loanable funds approach contends that the current rate of interest is
determined by the supply of and the demand for loanable funds.
 Future interest rates are therefore affected by changes in the demand and supply
of loanable funds.
 Loanable funds are the flows of funds into the market for securities.
Section 13.2
b. Extend your answer in (a) above and draw diagrams showing the demand curve, the
supply curve and the equilibrium interest rate. With each diagram, identify and
explain each of the components that comprise the supply and the demand curves, plus
discuss how the equilibrium interest rate is derived.
ANSWER
Demand for loanable funds:

There are two principal components:
 Business demand for funds—to finance its liquidity and capital investment
requirements. The lower the rate of interest, all else being constant, the greater
will be the volume of funds demanded. This is represented by the downward-
sloping curve (labelled B). Any factors that cause an increase (decrease) by
business in its demand for funds would be represented by a shift to the right (left)
in the B curve. The curve shown represents the net business demand for funds.
 Government sector demand for funds—the total public sector borrowing
requirement. This includes the Commonwealth, States and local governments and
their instrumentalities. It is normally proposed that the public sector borrowing
interest rate is independent of the market rate of interest, and this is represented
by the vertical curve labelled G. With a smaller (larger) borrowing requirement,
the G curve would be located further to the left (right) in the diagram. The two
demand curves are combined to give the total demand for loanable funds
(labelled G + B).
Supply of loanable funds:

There are three principal components:
 Savings of the household sector—the curve (S) is drawn with an upward slope on
the basis of the presumption that as interest rates increase people will save a
larger proportion of their incomes. The curve is steep because empirical evidence
suggests increases in interest rates cause only small increases in the quantity
saved.
 Changes in the money supply (M)—since the money supply is assumed to be
independent of the rate of interest, changes in the money supply are represented
diagrammatically as a vertical line. When M is added to the savings curve it
simply changes the location of the curve (S + M). It does not change the slope
of the curve. If, for example, the Reserve Bank increased the money supply, the
S + M curve would move to the right of the S curve.
 Dishoarding (D)—as interest rates increase, there is an incentive to acquire more
securities in order to obtain the increased yields that are available. In attempting
to buy more securities money is given up (or dishoarded). Dishoarding is added
to the S + M curve to give the total supply of loanable funds curve.
Equilibrium in the loanable funds markets:
 The equilibrium interest rate will be at the intersect of the demand and supply
curves.
Section 13.2
5 A problem with the loanable funds approach to explaining interest rates is that since
the supply and demand curves are interdependent, a unique equilibrium rate of interest
cannot be determined. Explain and illustrate this problem by reference to the effects of:
a. an increase in inflationary expectations using the basic Fisher effect, followed by

the non-Fisher effect
ANSWER
 The traditional approach to the analysis of the effects of inflation on interest rates
is shown below.
 The initial equilibrium interest rate is i0, at the intersection of the original
demand and supply curves.
 With an increase in inflationary expectations, the suppliers of funds will demand
a higher rate of interest in order to maintain the same real rate of return on their
funds. Diagrammatically, the supply curve will move vertically, by the extent of
the inflationary expectation (pe), from supply0 to supply1.
 The demand for funds will also change in response to the increased inflationary
expectation. The demand curve increases, by the extent of the inflationary
expectations, from demand0 to demand1.
 The demand for funds increases because businesses, in anticipating higher
inflation, recognise that they will require a greater quantity of funds merely to
maintain their pre-inflation investment plans.
 The result of the increased inflationary expectations is that interest rates will rise
to the full extent of the anticipated inflation, and the quantity of loanable funds
will remain unchanged at Q0.
 This is referred to as the Fisher effect.
 It may be argued that non-Fisher effects will be evident, which will lower the
equilibrium interest point.
 For example, increased inflation may reduce government demand for funds and
the demand curve will not move as far to the right.
 Also the supply curve may in fact move to the right rather than the left as savings
increase as a result of higher wages and increased superannuation contributions.
Section 13.2
b. an expectation of a decrease in the level of economic activity. (LO 13.2)

ANSWER
 An expectation of decreased economic activity may come from the business

sector.
 This will result in a decrease in business demand for funds to finance investment
projects due to an anticipated fall in demand.
 In a loanable funds demand and supply graph, the decrease in B would shift the
demand curve to the left, resulting in a decrease in the rate of interest.
 As businesses decrease their investment in inventories and in capital equipment,
they will reduce their need to borrow and sell financial instruments to obtain
funds.
 As the supply of financial instruments on the market decreases, the prices of
those instruments will rise and their yields will decrease.
 The higher prices on the securities (lower yields) will cause some savers to
reallocate their portfolios and sell securities; that is, hoarding will take place.
 The forecast decrease in interest rates is only a temporary equilibrium.
 There will be feedback mechanisms to consider in forecasting interest rate
changes further into the future.
 For example, the hoarding that accompanied the initial decrease in interest rates
will cease after the desired portfolio re-allocations have been completed
 With no further hoarding, interest rates may have to fall further in order to
prompt even more hoarding.
 The decrease in business investment adds to the expected decrease in economic
activity; as output levels fall, there will be a decrease in savings and this will
relieve some of the downward pressure on interest rates.
 In addition, the decrease in output will see a worsening in the government budget
position, with an associated increase in the government's borrowing requirement.
 The depreciation of the currency that might be expected to accompany the
decreased interest rate is likely to result in increased demand for exports and a
decrease in the demand for imports. Businesses in the export-competing and
import-competing sectors of the economy will increase their investment, and thus
increase their demand for funds. This will place some upward pressures on
interest rates.
Section 13.2
6 Interest rates play an important role in monetary policy determinations, economic

performance and the business cycle, and the cost of funds. Financial market
participants must therefore understand the term structure of interest rates. (LO 13.3)
a. Define in detail the term yield and explain how a yield curve is constructed.
ANSWER
 Yield—the total return on an investment; comprising interest receipts and any

capital gain or loss.
 Yield curve—a graph, at a single point in time, of yields on a specific type of
security with different terms to maturity.
 For example, it is possible to plot the yield, as at today, for bank bills that have
30 days, 60 days, 90 days and 180 days to maturity.
Section 13.3
b. Identify three different types of yield curves. Describe each of these yield curves
and draw a fully labelled diagram of each curve.
ANSWER
(1) Normal/positive/upward sloping yield curve—reflects the preference for higher

interest rates if funds are invested longer-term. Short-term rates are lower than
long-term rates.
(2) Inverse/negative/downward sloping yield curve—illustrates that yield declines

as maturity lengthens. Short-term rates are higher than long-term rates.
Humped yield curve—combines the normal yield curve and the inverse yield
curve and joined by a period of a flat or horizontal yield curve.
Section 13.3
7 Market participants observe that the yield curve is normal (upward sloping). Use
expectations theory to explain this observation. (LO 13.3)
ANSWER
 Expectations theory—the shape of a yield curve is a function of the current and

future short-term interest rates.
 That is, the return received on a continuous series of short-term investments
should be the same as that received for a longer-term investment.
 An investor will therefore be indifferent as to whether they invest for a short
period or a longer period.
 For example, an investor has two options: (1) invest today for a one-year period
at 4 per cent per annum and reinvest the funds in 12 months time; or (2) invest
the funds today for a two-year period at 4.5 per cent per annum. The expectation
theory will contend that the one-year investment rate in 12 months time should
be 5 per cent per annum (that is, 4.5% x 2 = 9% - 4% = 5%)
 The expectations theory implies that the yield curve is upward sloping because
market participants expect interest rates to increase. To be precise, future short-
term interest rates are expected to be higher than current short-term interest rates.
Section 13.3
8 Over time, market participants observe that the yield curve has changed from being
upward sloping to being downward sloping. Use expectations theory to explain why the
yield curve has changed shape.(LO 13.3)
ANSWER
 A normal yield curve will result from expectations that future short-term rates
will be higher than current short-term rates.
 An inverse yield curve will result if the market expects future short-term rates to
be lower than current short-term rates.
 An inverse yield curve may emerge even though the central bank may increase
rates at the short end of the yield curve to achieve its monetary policy objectives.
 Market participants expect that once those objectives have been achieved, short-
term rates will be lowered again.
 In this circumstance, long-term rates will not rise to the same extent as the
policy-induced change in short-term rates, and therefore the yield curve will
slope downwards.
Section 13.3
9 The segmented markets theory extends our understanding of factors that influence
the determination of interest rates. (LO 13.3)
a. Identify and explain two assumptions of the expectations approach that are
challenged by the segmented markets approach to interest rate determination.
ANSWER
The segmented markets theory rejects two expectation theory assumptions:

(1) All bonds are perfect substitutes for one another.
(2) Investors are indifferent between holding instruments with a short term to
maturity and holding instruments with a long term to maturity.
 Securities in different maturity ranges—for example, a 1 to 3 year range versus a

9 to 10 year range—are not viewed by various market participants as being
perfect substitutes for one another.
 Whereas bonds with a very short term to maturity may well be close substitutes
for each other, and likewise for bonds with long terms to maturity, a one-month-
to-maturity bond is unlikely to be seen as a close substitute for a 10-year bond.
 Some market participants have a preference for short-dated securities, and others
have a preference for longer-term maturities.
 That is, different investors have preferences for different segments of the market.
 The particular preferences are motivated out of a desire by the various
participants to reduce the riskiness of their portfolios.
 Investors will seek to minimise their exposure to fluctuations in the prices and
yields associated with their assets and liabilities by matching the cash flows and
maturities of their assets and liabilities.
 For example, life offices have mainly long-term liabilities and therefore tend to
hold more longer-term assets.
 The implication of the segmented markets approach is that it is the relative
demands for and supplies of securities in the various maturity ranges that
determine yields.
 The shape and slope of the yield curve are determined by the relative demand and
supply conditions that exist along the maturity spectrum.
Section 13.3
b. It may be argued that the segmented markets approach is negated by modern risk
management practices, arbitrage and speculation. Explain what is meant by this
assertion.
ANSWER
 The segmented markets approach emphasises the risk management motivation of

market participants.
 That is, the matching of cash flows and maturities of assets and liabilities in order
to minimise associated risk exposures.
 By implication, this approach would cause discontinuities in a yield curve, thus
exposing significant speculation and arbitrage opportunities.
 Arbitrageurs, who are indifferent about the maturity of the bonds they hold, will
sell and buy to take advantage of the discontinuities along the yield curve.
 Their actions will smooth out the yield curve; that is, remove the segmentation
distortions.
 Therefore, it may be reasonable to argue that certain investors do have segment
preferences along a yield curve, but those preferences are balanced by investors
with different preferences: arbitrageurs and speculators.
Section 13.3
10 If financial market participants considered that anticipated inflation would rise

significantly in the future, what effect would you expect this forecast to have on the
slope of a normal yield curve? Why? (LO 13.3)
ANSWER
 A normal yield curve is upward sloping.

 Yields on a particular security are higher as the term to maturity increases.
 The nominal interest rate (yield) on an investment mainly incorporates a

component for the real rate of interest and a component for anticipated inflation.
 Therefore, all other impacts being equal, an anticipation of an increase in inflation
over time should push up nominal interest rates further out on the maturity
spectrum.
 As indicated in the graph below, the slope of the yield curve will become steeper.
Section 13.3
11 The liquidity premium theory seeks to extend our understanding of the expectations
theory and the determination of interest rates. (LO 13.3)
a. Outline the principal contention of the liquidity premium theory.

ANSWER
 A criticism of the pure expectations approach is its assumption that investors are
indifferent as to whether they hold long-term or short-term bonds.
 There is one important characteristic that distinguishes short-term and longer-
term securities that may result in a violation of the assumption of indifference.
 Longer-term-to-maturity bonds are susceptible to a greater risk of larger price
fluctuations than are shorter-term instruments.
 Given the greater price risk associated with longer-term securities, it may be
hypothesised that investors require a premium if they are to be enticed away from
the shorter end of the maturity spectrum.
 If this is the case, then the expectations hypothesis explanation of the level of
longer-term rates may be presented as being approximately:.
❑ ( ❑0i1+ E 1 i1 ) + L
i=
0 2
2
 Where L is the liquidity premium that is demanded in order to hold the higher
risk, longer-term security.
 The size of L is likely to increase the longer the term to maturity of the particular
instrument.
 The effect of the liquidity premium on the expectations hypothesis is shown
below:
Section 13.3
b. How does the historic prevalence of a normal yield curve provide indirect evidence
of the existence of a liquidity premium?
ANSWER
 Support for the addition of the liquidity premium to the expectations hypothesis is
derived from observations of the shape of the yield curve over time.
 The positive or upward-sloping curve is labelled as the ‘normal’ yield curve.
 The normal yield curve is typically the shape most frequently observed over the
years.
 The combination of the expectations theory and the liquidity premium explains
the observed dominance of the normal curve.
 At times, even though the pure expectations outcome is an inverse curve, when
the liquidity premium is added to the curve it results in a positive or normal curve.
 At other times, the slope of an inverse yield curve will become flatter as a result
of the effect of the liquidity premium; that is, the inverse curve will move upward.
Section 13.3
c. Does the existence of an inverse yield curve indicate a violation of the liquidity
premium contention?
ANSWER
 No, an inverse yield curve is still possible.

 In this instance, the downward slope of the inverse yield curve will be reduced by
the liquidity premium effect. That is, the yield curve will become flatter, but still
retain an inverse slope.
Section 13.3

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Chapter 13 End-chapter essay questions solutions

Monetary policy is principally directed towards containing inflation within a target

 the underlying rate of inflation over the business cycle

2 The macroeconomic context of interest rate determination attempts to explain the

a. List the three effects

(i) Liquidity effect:

(ii) Income effect:

(iii) Inflation effect:

 In so far as the economy was previously experiencing inflationary pressures due

3 Market participants, including financial institutions, funds managers and

 The principal objective of current monetary policy is to implement monetary

 The business cycle is a measure of changes in the level of economic activity in an

Demand for loanable funds:

Supply of loanable funds:

a. an increase in inflationary expectations using the basic Fisher effect, followed by

b. an expectation of a decrease in the level of economic activity. (LO 13.2)

 An expectation of decreased economic activity may come from the business

6 Interest rates play an important role in monetary policy determinations, economic

 Yield—the total return on an investment; comprising interest receipts and any

(1) Normal/positive/upward sloping yield curve—reflects the preference for higher

(2) Inverse/negative/downward sloping yield curve—illustrates that yield declines

 Expectations theory—the shape of a yield curve is a function of the current and

The segmented markets theory rejects two expectation theory assumptions:

 Securities in different maturity ranges—for example, a 1 to 3 year range versus a

 The segmented markets approach emphasises the risk management motivation of

10 If financial market participants considered that anticipated inflation would rise

 A normal yield curve is upward sloping.

 The nominal interest rate (yield) on an investment mainly incorporates a

a. Outline the principal contention of the liquidity premium theory.

 No, an inverse yield curve is still possible.

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