Question

ECON350 Tue or False Practice Questions (week 5)

1. It is often the case that purchasing a five-year bonds or five one-year bonds always results in the same returns, hence investors are indifferent between these two options.

2. The YC under the liquidity premium theory is normally upward sloping, but it might kink downward at the very long end of maturity.

3. As debtors are more sensitive to interest rate changes than creditors, higher interest rates would lead to a negative net cash flow.

4. In conducting Open Market Operations, the Reserve Bank of Australia buys or sells only short-dated commonwealth government securities.

5. Central banks conduct their micro function via the regulation and supervision, and the lender of last resort facility.

6. On most days, the RBA conducts OMO to keep the cash rate in the overnight market near the target cash rate.

7. As banks in Australia are required to hold an ES account at the RBA while no individuals or firms have such an account, a change in the target cash rate announced by the RBA will only affect commercial banks, not the broader economy.

8. The RBA does not set the inflation target at zero because it believes that some inflation ‘greases the wheels’ for relative price flexibility.

9. The metaphor “A horse could be led to water, but it could not be made to drink” implies that if the CB floods the market with liquidity to push the interest rate down, firms would increase their borrowings to build factories and buy machines.

10. The issue of central bank independence emerged with stagflation and the collapse of Bretton Woods system in the 1970s.

Answer 1

1. It is often the case that purchasing a five-year bonds or five one-year bonds always results in the same returns, hence investors are indifferent between these two options.

False

Even if the bonds are otherwise similar, the 5-year bonds have an added component (markup) for maturity risk in the yield which is the premium for longer duration of the bonds. Additionally, the longer maturity bonds also usually have higher duration which is the sensitivity of the bond prices to the changes in interest rates. Hence, their risk profiles are not same and investors are not indifferent between those two.

2. The YC under the liquidity premium theory is normally upward sloping, but it might kink downward at the very long end of maturity.

False

The liquidity premium theory or liquidity preference theory proposes that as the securities more illiquid, the investors demand higher compensation (premium) for holding them. all else being equal, the investors prefer security with higher liquidity. As the liquidity usually goes down as the maturity of bonds increases, the yield curve is upward sloping for short to medium duration but the slope gradient decreases i.e. slope becomes less steep for long to very-long duration securities.

3. As debtors are more sensitive to interest rate changes than creditors, higher interest rates would lead to a negative net cash flow.

False

The sensitivity to interest rate changes depends on the duration and overall portfolio composition. Higher interest rates would not create negative cash flow as the decrease in price of the debt due increase in interest rate and the coupon / interest payments are in opposite direction

4. In conducting Open Market Operations, the Reserve Bank of Australia buys or sells only short-dated commonwealth government securities.

False

The target of OMO is to influence short-term rates. However, the central banks such as RBA do not restrict themselves to the short-dated securities. There have been incidences in the past when the central banks have traded longer term securities under the OMO.

5. Central banks conduct their micro function via the regulation and supervision, and the lender of last resort facility.

False

Central banks act as the lender of last resort to the participating banks and the governments. This is a way of affecting micro economy through micro functions. They are also responsible to regulate the banking system in the country and supervise the participating banks under its macro functions.

6. On most days, the RBA conducts OMO to keep the cash rate in the overnight market near the target cash rate.

False

RBA does not conduct OMO to influence the overnight market rates. The target official cash rates are decided through the periodic meetings of RBA. It does not limit the amount of transactions at this rate.

7. As banks in Australia are required to hold an ES account at the RBA while no individuals or firms have such an account, a change in the target cash rate announced by the RBA will only affect commercial banks, not the broader economy.

False

The banks are required to hold an ES account. No individuals or firms can have such accounts. The target cash rates announced by the RBA do influence the lending rates of the participating banks. The lending rates for mortgage, vehicle loan etc. are based on this target cash rate and affects the broader economy

8. The RBA does not set the inflation target at zero because it believes that some inflation ‘greases the wheels’ for relative price flexibility.

False

No central bank sets the target inflation rate at zero. The inflation targets are low (2-3% for Australia) but not zero as there is a high risk of economy going into the deflation and –ve growth cycle. It becomes extremely difficult to control the economic cycles and interest rates at zero inflation rate. Relative price flexibility is the by-product but not the main motivation for +ve inflation target

9. The metaphor “A horse could be led to water, but it could not be made to drink” implies that if the CB floods the market with liquidity to push the interest rate down, firms would increase their borrowings to build factories and buy machines.

False

The methaphor would actually imply that if the CB floods the market with liquidity to push the interest rate down (leading horse to eater), firms would still not borrow more for capital investment (horse not drinking the water). The general theory is that at lower interest rates, the firms would increase capital investments and the economy would pick up again. However, it has been observed in the past that even zero or –ve interest rate have been unable to promote borrowing and capital investments in economy in lack of confidence in the economy. This was observed in 2008 financial crisis.

10. The issue of central bank independence emerged with stagflation and the collapse of Bretton Woods system in the 1970s.

False

The Bretton Woods system collapsed in the 70s when the USA was not able to maintain the inflation, debt and the value of dollar in the international market. After the agreement broke, the countries changed their currency system from pegged to free float. The central banks technically became more independent to set the target exchange rates for their countries as the rates were no longer pegged to gold or USD.