Tutorial assignment: week 3 2022
Answer guide
1. Recent media reports suggest that the general level of interest rates may soon begin to increase worldwide. What effects do you think this would have on the decisions of savers, borrowers with a mortgage, businesses and governments? Hence, what would be the likely effect on the economy overall?
Savers are people with surplus funds which can be loaned at interest, for example in the form of bank deposits or direct loans. An example would be retirees with accumulated assets. If interest rates rise, savers are better off because their interest income rises. The effect on their spending decisions is ambiguous. The increase in income would allow them to spend more, but the higher interest rate also provides an incentive to save more. The overall effect will depend on which of these effects is stronger.
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Mortgage borrowers will be worse off because their loan repayments are increased. They will be likely to reduce their spending on goods and services because disposable income is reduced. In addition, the higher interest rate will give them an incentive to pay off their loans more quickly than otherwise. This reinforces the downward impact on their likely spending decisions.
Businesses generally have significant debts, so their interest payments will rise and profits fall. This will make it more difficult for them to employ workers or to invest in productive capacity (like machinery, equipment, premises). Furthermore, when interest rates are higher it will be more difficult for businesses to justify borrowing to fund new activities, because those activities would need to earn a higher rate of return to be profitable after interest payments.
Governments also usually have large debts (recall the data from the lecture showing the amount of government bonds on issue). So government interest payments will rise and fiscal deficits will rise. Governments may respond by cutting spending or increasing taxes to limit the rise in their deficits.
The overall impact is likely to reduce spending, employment and incomes for the economy as a whole, since most of the effects described above work in that direction. These effects also interact with and reinforce each other: when spending in one part of the economy is reduced, it tends to reduce incomes and spending in other parts of the economy at the same time. Reduced spending and employment would in turn be likely to lead to lower inflation: when there is less demand for goods and services, prices are likely to rise less quickly than otherwise.
2. Based on your answers to the previous question, what considerations might a central bank take into account in deciding whether to change the policy interest rate?
Note that interest rates can move either up or down: a reduction in interest rates would have the reverse of the effects described for Q1.
In deciding whether to change the policy interest rate, and in which direction, a central bank would aim to have a stabilising influence on the economy as a whole. Hence, if the central bank thought that spending and inflation were likely to be higher than desired, they would consider raising the policy rate to counteract that. Conversely, if spending and inflation were likely to be lower than desired, they would consider lowering the policy rate. (These decision-making principles will be studied in more detail later in the course.)
3. How would a rise in the value of the Australian dollar against other currencies be likely to affect the following: (a) an Australian mining company selling aluminium abroad at a price fixed in US dollar terms; (b) international travellers who are considering whether to have their next holiday in Australia or elsewhere; (c) an Australian manufacturer of medical supplies competing with imported products; (d) a retiree from Italy now living in Australia, who has a pension denominated in euros.
(a) Profits of this company would fall. Since this is an Australian producer, the cost of production can be assumed stable in Australian dollar terms. At the same time, the revenue from selling aluminium is fixed in US dollar terms, so revenue in Australian dollar terms will fall when the exchange rate appreciates. A simple numerical example can illustrate, assuming the AUD appreciates from 1AUD=0.50USD to 1AUD=1USD:
Exchange rate (USD per AUD)
Price of Aluminium per tonne (in USD)
Price of Aluminium per tonne (in AUD)
Cost of production per tonne (AUD)
Profit per tonne (AUD)
(b) International travellers are less likely to come to Australia. The AUD is now more expensive and so the relative cost of an Australian holiday has increased compared to other destinations.
(c) The relative price of imported products falls. Hence, an Australian producer would find it more difficult to compete and would likely face reduced demand for the Australian product.
(d) This is essentially the same situation as (a), since income is fixed in foreign currency terms. The pensioner’s income falls in AUD terms. And since they are resident in Australia, their cost of living in AUD terms is unchanged, so the person is worse off.
4. From the RBA website, find the most recent statement (prior to March 2022) by Governor Lowe announcing the outcome of a meeting of the RBA Board. What does the statement say about the RBA’s current thinking and intended policy actions?
The most recent statement was on 1 February 2022. Key points:
· The Omicron outbreak has affected the economy but not ’derailed the recovery’.
· Growth over the next two years is expected to be strong, but the pandemic is still the main source of uncertainty.
· The labour market is performing strongly with high employment growth, falling unemployment and rising wages.
· Consumer price inflation is rising. Part of that is due to temporary supply chain disruptions caused by the pandemic, but there is also an underlying trend towards higher inflation.
· But this follows a period when inflation undershot the target, so the RBA wants inflation to rise.
· The RBA has been trying to stimulate the economy with low interest rates and bond-buying activity.
· It has decided to end the bond buying program because it is seeing progress towards its goals.
· The final paragraph is indicating that interest rates will stay low for some time. They will eventually need to be raised to more normal levels, but not until there is stronger evidence of higher inflation.
· Hence, the Bank will be ‘patient’.
· Overall, the statement is meant to indicate that the cash rate will rise, but not soon.
5. Go to the Statistics section of the RBA website and find a table showing daily exchange rates for the Australian dollar.
a. What was the exchange rate of the Australian dollar against the US dollar on 30 June 2020, and on 31 December 2021?
These figures can be found in Table F11.1 (Column B) [navigating from home page: Statistics>>Economic and Financial Statistics>>Exchange Rates>>link to F11.1]
30/6/2020: 1AUD = .6863USD
30/12 /2021: 1AUD = .7256USD
b. Did the Australian dollar appreciate or depreciate against the US dollar over this period, and by what percentage?
Appreciated – it now buys more USD than previously. The percentage increase in value of the AUD comes from the ratio of the two figures: 5.73 per cent (to two decimal places).
c. Suppose an Australian business had borrowed $10million US dollars from an American bank at end June 2020 in order to invest in its activities in Australia, with the loan scheduled to be repaid at end December 2021. What was the Australian dollar value of the debt at the time of the borrowing and at the time of repayment?
June 2020: 10 mil USD = (10mil/0.6863) AUD = 14.571 mil AUD
December 2021: 10 mil USD = (10 mil/.7256) AUD = 13.782 mil AUD
d. What does your answer to c. imply about the potential risks and benefits of borrowing in a foreign currency?
The amount of the debt expressed in AUD terms has fallen because the AUD has appreciated. In other words, because the AUD now has a higher value, it takes less Australian dollars to pay off a foreign currency debt than at the time when the loan was made.
Risks and benefits: A borrower of foreign currency benefits if the domestic currency appreciates during the period between borrowing and repayment. Conversely, the same borrower would be made worse off if the domestic currency depreciates in that period. Since the direction of future movement in the exchange rate at the time of borrowing is unpredictable, borrowing in a foreign currency is a risky proposition.
6. A ‘loan shark’, colloquially, is a lender who is prepared to make loans more easily available but at a substantially higher interest rate than conventional lenders. Why might a loan shark be less worried about the moral hazard problem than a conventional lender like a bank?
Moral hazard, in a loan contract, refers to the incentive of the borrower to behave in ways that are against the interests of the lender after the loan has been made – in other words, to make decisions that reduce the likelihood of the loan being repaid in full. This might include using the borrowed funds recklessly (eg, gambling, overspending on holidays, drugs) or simply absconding with the money. Borrowers have an incentive to behave in this way because part of the cost of their actions falls on someone else.
Lenders will try to manage the moral hazard problem using enforcement mechanisms to make it harder for the borrower to avoid repayment. Standard examples include collateral requirements (as in a home mortgage) or enforceable covenants on how the borrowed funds can be used. Conventional lenders such as banks however are likely to be reluctant to use enforcement measures that could be seen as too harsh (example: banks pursuing struggling farmers during a drought). In contrast, a loan shark may be more willing to use tougher enforcement measures. At the softer end of the spectrum, this might include investing in a reputation for pursuing debtors in court so as to deter non-repayment. Violent enforcement of drug or gambling debts would be an extreme example.
7. Give an example of direct and an example of intermediated finance. What sorts of factors might influence the relative attractiveness of each form of finance to borrowers and lenders?
Example of direct finance: A loan from your parents to help you buy your first home. This is fairly common in Australia.
Example of intermediated finance: You take out a bank loan to buy a home (this is in fact the most common form of lending in Australia). Second example: a household buys bonds issued by a large company like BHP.
Main advantages of direct finance:
· Avoids cost of intermediation
· Problems of asymmetric information are not present provided there is a relationship of trust between the borrower and lender
Main advantages of intermediated finance:
· Avoids cost of finding a matching counterparty
· Intermediary has expertise in credit risk assessment (to deal with adverse selection)
· Intermediary can employ appropriate enforcement mechanisms (to deal with moral hazard)
· Intermediary can provide liquidity services (access to loaned funds at short notice)
The relative attractiveness of the two types of finance will depend on the characteristics of the borrower and lender.
Direct finance will likely be more attractive where:
· There is a relationship of trust between borrower and lender (eg family members)
· Borrower has a strong public reputation as a good credit risk (eg, government, large corporation)
For the same reasons, intermediated finance will be favoured by smaller and less well-known borrowers, or where there is no pre-existing trust relationship between borrower and lender.
8. Suppose you have a temporary surplus of funds which you hope to invest at a profit. In order to do so, you decide to advertise your willingness to make direct loans to suitable customers on social media. How might the profitability of this activity be affected by problems of asymmetric information? What actions could you take to manage such problems?
There are two problems associated with asymmetric information in this context:
· Adverse selection. Your social media ad is likely to attract a pool of borrowers who can’t get a loan from a conventional lender. This probably means they have poor repayment prospects.
· Moral hazard. You lack expertise in loan enforcement, so you are likely to experience a greater than normal incidence of poor borrower behaviour after a loan is made.
Both problems are likely to contribute to a high default rate on your loans, which will make it harder to earn a profit on this activity. You could try to offset these effects by charging a higher interest rate. However, this would worsen both problems. The more you raise your interest rate, the more likely you are to discourage good borrowers who can’t get a loan elsewhere. This worsens adverse selection. It would also worsen moral hazard by strengthening the incentive for the borrower to avoid repayment.
Hence, without significant investment in financial intermediation capacity (credit assessment, enforcement tools and the like), your money lending enterprise is unlikely to succeed.
9. During the 19th century American businesses were heavily funded by British investors to finance railroad construction. How could this have made both economies wealthier?
This is an example of how financial flows can increase economic efficiency. During the 19th century the American railway system was less developed than in Britain. Since the British economy was more advanced at that time, British investors had surplus funds available to invest elsewhere, while the profitability of investment in new railroads was higher in America than in Britain.
· British investors were able to earn higher returns than if they had been forced to invest surplus funds domestically
· The US railroad system could be developed more quickly than would have been possible if they had been unable to borrow from abroad.
10. Suppose a friend came to you with the following proposition. ‘Equity prices usually rise. Therefore, it’s a safe bet to borrow money and invest in shares. Once their price goes up, I can sell the shares, repay the loan and keep the profit.’ What advice would you give about such a strategy?
Some relevant points:
· On average, equity prices do tend to rise over time
· However, in any given period, the direction of movement is uncertain
· We saw in the lectures that equity prices fell by more than 50% during the GFC
· They fell by about 40% on a single day (known as , October 19 1987)
· These movements are not predictable beforehand
· Borrowing to buy a risky asset amplifies the risk as well as amplifying the return
· Example: consider two cases where an investor starts off with zero net worth and borrows $10,000 to buy equities:
· Case 1. equity prices rise by 50%.
· Result: you can sell the shares for $15,000, payoff the loan, and achieve a net profit of $5,000 after starting with nothing.
· Case 2: equity prices fall by 50%.
· Result: you end up with only $5,000 worth of shares but a $10,000 debt.
· General principle: borrowing to buy risky assets amplifies both risk and returns
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