Question

1.In the long-term nominal Overnight policy

rate(opr) or the long-term real OPR that influences spending decisions? Explain why?

2.how does the market determine the long term nominal OPR and why doesnt is move

as much as the short term OPR

Answer 1

1) The real long-term interest rate impacts the spending decisions. The real rate of interest strips out the inflation effects and measures the real cost to borrowers (i.e. borrowing cost in terms of products and services). The real rate of interest also measures real return to savers’ (i.e. saving return in terms of products and services). Firms are keen to determine real cost and savers in the real return while make the decisions on the investment and saving.

2) The short-term interest rate fluctuates more compared to the long-term nominal interest rate because the interest rate in long-term is an expected average of interest rates in short-term. People can either save or borrow by making a commitment for long-term or by making successive commitments in short-term. The average of the rates of interest on the short-term commitments must be equal the long-term rate of interest when adjusted for risk. When they were not equal it depicts that one borrowing method would be less or more expensive than the other. By using the less expensive method people would stream to borrow thus increasing the interest rate higher, back toward equality. Moreover other people simultaneously would stream to save with the usage of the method with the higher return, thus lowering the rate of interest rate and moving back toward equality.

The current short term interest rate fluctuates more than the expected average future short-term interest rates, so the rate of interest in long-run, comprised of the expected future short-term rates of interest, fluctuates less compared to current short-term rate of interest