Question 5

The RBA intends to use open market operations in addition to reducing the cash rate.

Assume that a bond with no expiration date pays a fixed $3,600 annual interest and is selling for its face value of $75,000.

(i) Calculate the interest yield on the bond.

(ii) Will the RBA buy or sell bonds if it uses open market operations? Briefly explain.

(iii) As a result of the RBAs decision above, which of these two outcomes is more likely or correct? In your answer calculate the new interest yield after the RBAs open market operations; show your workings.

• The market value of the bond will increase to $90,000 OR

• The market value of the bond will decrease to $50,000.

(iv) Briefly explain why the market value and yield of the bond has changed.

(v) Assume that bank deposits increase by $2,500 million as a result of RBA monetary policy. Also assume that banks hold 12.5% of deposits as reserves.

Calculate the following:

• the banks excess reserves after the increase in bank deposits;

• the maximum amount by which the money supply can expand due to credit creation, if banks decide to lend out their excess reserves.