Interest rates

[DoctorTwo]

One thing that I have been struggling to understand is interest rates. Question 11 (which is multiple choice) of the 2012 VCAA Economics exam asks 'If Australia’s interest rates fall relative to overseas interest rates, the most likely effect would be'. The answer is option C: 'a fall in capital inflow and a depreciation of the Australian dollar.', but I thought the answer would have been question B, which is the exact opposite response to question C. If Australia's interest rates fall, don't overseas businesses want to take advantage of the cheaper credit, therefore increasing capital inflow? Also, wouldn't the increased demand for the Australian dollar, as a result of the decrease in interest rates, cause it to appreciate?
I'm not sure if I've gotten something wrong about interest rates but I've been struggling with this one issue for a while. I'd appreciate any help. Thanks.

[S200]

One thing that I have been struggling to understand is interest rates. Question 11 (which is multiple choice) of the 2012 VCAA Economics exam asks 'If Australia’s interest rates fall relative to overseas interest rates, the most likely effect would be'. The answer is option C: 'a fall in capital inflow and a depreciation of the Australian dollar.', but I thought the answer would have been question B, which is the exact opposite response to question C. If Australia's interest rates fall, don't overseas businesses want to take advantage of the cheaper credit, therefore increasing capital inflow? Also, wouldn't the increased demand for the Australian dollar, as a result of the decrease in interest rates, cause it to appreciate?
I'm not sure if I've gotten something wrong about interest rates but I've been struggling with this one issue for a while. I'd appreciate any help. Thanks.

Well, if you have US$1M to invest, and the Aussie interest rates go down, you won't be looking to invest there, will you. You will go elsewhere, for a higher ROI. That would decrease capital inflow, affecting the CAD etc. But I don't know how the AUD value would be affected...

[DoctorTwo]

I thought interest rates referred to the cost of borrowing credit? e.g. a 2% interest on borrowing $100 means that you'd have to pay back $102? If interests go down, the lendee would pay less to the lender, so they're more likely to invest?

[S200]

I thought interest rates referred to the cost of borrowing credit? e.g. a 2% interest on borrowing $100 means that you'd have to pay back $102? If interests go down, the lendee would pay less to the lender, so they're more likely to invest?

As I see it, interest rates work both ways.
The lower they are, the more likely people are to borrow (less repayment) and the less likely people are to invest (lower ROI).
In your example, the Lender is actually the investor...

[DoctorTwo]

Why would people be less likely to invest if they pay less back on loans though?

[S200]

Why would people be less likely to invest if they pay less back on loans though?

I think you are confusing the two terms.
Taking out a loan due to favorable (lower) interest rates isn't counted as an investment.

If you are taking out a loan, you aren't actually getting any assets back, are you? You are just increasing your liabilities.

The lender, however, is getting some return (the interest), over and above the principle amount , so he is making an investment. If the national interest rate lowers, the Lender will be less inclined to offer loans, because they are getting less return on their investment.

[DoctorTwo]

Okay, so lenders are less inclined to offer loans and then capital inflow falls because credit isn't as accessible to businesses as before? And then I'm assuming the fall in demand for the AUD as a result will cause the dollar to depreciate?

[S200]

Okay, so lenders are less inclined to offer loans and then capital inflow falls because credit isn't as accessible to businesses as before?

And then I'm assuming the fall in demand for the AUD as a result will cause the dollar to depreciate?

Yeah, I guess. I certainly don't have any better ideas about the depreciation part of it.

[Chelsea f.c.]

It may sound weird because with low interest rates capital is cheap for businesses so stocks are high but the questions usually refer to bonds.

With low interest rates the return on government accounts (rba) and bonds is low as interest is what an investor is paid. Investors looking for high interest rates will go overseas I.e. Selling their bonds cashing in the local currency and buying bonds overseas (notice as interest rates have increased in the us over the last period the Aussie dollar has depreciated from 80 to 75 cents though don't talk about yesterday)

With a low dollar exports are attractive as I pay less for your currency and hence your goods (maybe check current account from last night  ) which means companies have high profits investment more money and increase GDP (e.g. 1% quarter according to some sources).

Hopefully this story makes sense 

[S200]

snip

It may sound weird because with low interest rates capital is cheap for businesses so stocks are high but the questions usually refer to bonds.

With low interest rates the return on government accounts (rba) and bonds is low as interest is what an investor is paid. Investors looking for high interest rates will go overseas I.e. Selling their bonds cashing in the local currency and buying bonds overseas (notice as interest rates have increased in the us over the last period the Aussie dollar has depreciated from 80 to 75 cents though don't talk about yesterday)

With a low dollar exports are attractive as I pay less for your currency and hence your goods (maybe check current account from last night  ) which means companies have high profits investment more money and increase GDP (e.g. 1% quarter according to some sources).

Hopefully this story makes sense 

Kinda doesn't to me.

You said that people will cash in bonds here and start buying in other countries. But if they did that, why wouldn't that make the AU$ appreciate?? (higher demand and all that from converting bonds to cash...)

[Chelsea f.c.]

The idea is you need local currency to buy local bonds we are not increasing demand for bonds we are decreasing and hence Aussie dollar as they buy us bonds in US dollar as us interest rates rise... there's a difference between stock and flow where GDP is not stock but flow and investment is new investment... ideally we are talking about arbitrage where us bonds have higher rates of return and people who yesterday said Aussie bonds were good and where thinking about buying Aussie bonds in Aussie dollars say now hang on us bonds are better so I'll buy US dollars to buy us bonds... in macroeconomics we assume all bonds have same return and currencies on the market will appreciate or depreciate to match this as government bonds have no risk (adding risk will decrease price I.e. Italy) and are substituble for one another so arbitrageurs will sell high and buy low...
Are you convinced???

[S200]

The idea is you need local currency to buy local bonds we are not increasing demand for bonds we are decreasing and hence Aussie dollar as they buy us bonds in US dollar as us interest rates rise... there's a difference between stock and flow where GDP is not stock but flow and investment is new investment... ideally we are talking about arbitrage where us bonds have higher rates of return and people who yesterday said Aussie bonds were good and where thinking about buying Aussie bonds in Aussie dollars say now hang on us bonds are better so I'll buy US dollars to buy us bonds... in macroeconomics we assume all bonds have same return and currencies on the market will appreciate or depreciate to match this as government bonds have no risk (adding risk will decrease price I.e. Italy) and are substituble for one another so arbitrageurs will sell high and buy low...
Are you convinced???

I think I get where you are coming from. Would I be right in saying that regardless of those that have already brought Aussie bonds, if the interest rates fall, the people that were thinking of buying them will now stop and find elsewhere to invest their money? - Hence, causing less demand for AUD, and leading to depreciation...

[Chelsea f.c.]

Also you should know that it's not the average highest lowest or any other investor but the marginal investor that sets the price... global interest rates are relative to one another but all investors should expect the same return from the same product right =) so if I get a higher interest from us bonds than aud bonds I bid up the price of us in US dollars and reduce my bid on us... you may have heard of treasury bonds when go to market do not pay interest a finance example is that the price of a treasury bond will be set to the prevailing interest rate otherwise I'd rather stick money in a term deposit... the bond sells regardless if interest rates high or low but it's just at what price would I be indifferent =)

[Chelsea f.c.]

*aud

[S200]

Also you should know that it's not the average highest lowest or any other investor but the marginal investor that sets the price... global interest rates are relative to one another but all investors should expect the same return from the same product right =) so if I get a higher interest from us bonds than aud bonds I bid up the price of us in US dollars and reduce my bid on us... you may have heard of treasury bonds when go to market do not pay interest a finance example is that the price of a treasury bond will be set to the prevailing interest rate otherwise I'd rather stick money in a term deposit... the bond sells regardless if interest rates high or low but it's just at what price would I be indifferent =)

So this is like Macroeconomics, but looking internationally rather than focusing on flow just in and out of Australia?

This is prolly more like Uni Economics rather than VCE Eco, but thanks heaps for the general knowledge...

EDIT> You can modify post rather than double posting...