ACST101 Tutorial Solutions Topic 1 (to discuss in week 2 Tute) 2018

Financial System (5 minutes)

1. Study the below diagram which shows the net loans between various sectors of the economy at June 2017. The direction of the arrows depicts the direction that loans moneys flowed. Eg. Rest of World lent money to the Government in Australia and is therefore owed

198.6bn

Source: ABS, Sept 2017. Intersectoral Financial Flows. Accessed at:

http://www.abs.gov.au/ausstats/abs@.nsf/Latestproducts/5232.0Main%20Features4Jun%202017?opendocument&tabname=S ummary&prodno=5232.0&issue=Jun%202017&num=&view=; Accessed 6 December, 2017

- a) Who are the biggest savers/lenders in Australia (ignore the net amount contributed by ‘Rest of World)? HOUSEHOLDS_____
- b) Who are the biggest spenders/borrowers? CORPORATIONS__________
- c) The Financial Corporations have money owed to them and money owed by them. How
might you describe their position based on your Lecture 1 knowledge?

ACST101 Tutorial Solutions Topic 1 (to discuss in week 2 Tute) 2018

FINANCIAL INTERMEDIARIES which borrow (eg accept deposits) from savers/lenders and lend to Borrower/Spenders

Determinants of interest rates (5 minutes)

2. For the following, indicate the most immediate impact on interest rates. Answer Increase/ Decrease/ No Change

– Increase in wages following shortage of skilled labour (low unemployment)

(People begin to spend inducing businesses to grow and demand more borrowings)

– Decrease in Corporate taxes

INCREASE

INCREASE

(This will encourage businesses to grow and invest putting upward pressure on rates…much as the

US government hopes to do)

- – An increase in expected inflation Nominal rate INCREASE
- – A breakthrough in new robotics technology Generally INCREASE in rates
follows technological advancements given greater business investment and demand for funds.

ACST101 Tutorial Solutions Topic 1 (to discuss in week 2 Tute) 2018

Nominal rate vs Real rate of interest (15 minutes)

3.

Suppose you borrow $500 from your friend, agreeing to pay him back the $500 plus 7% nominal interest in 12 months’ time. Assume inflation over the life of the contract is expected to be 4.25%.

a) What is the total dollar amount you will have to pay back?

b) Using the simplified Fisher Equation, what is the real interest rate? The (simplified) Fisher Equation: i ≈ r + ∆Pe

i = nominal (market) rate of interest;

r = ‘real’ rate;

∆Pe = expected annualised price-level change (rate of inflation).

c) Recalculate (b) using the exact Fisher Equation to calculate the real rate of interest. The (full) Fisher Equation:

r =(1+i)/(1+∆Pe)-1

i.e. 2.64% (with rounding).

d) If the nominal interest on the loan is fixed, what happens to the real rate of interest in (c) if the magnitude of the expected annualised price-level change (rate of inflation) increases by 1 percentage point i.e ∆Pe = 4.25%+ 1%.

Future Value= Amount borrowed + (Amount borrowed * interest rate charged) Or, FV= Borrowing (1+i)

$500 + $(500 * .07) = $500 + $35 = $535.

r ≈ 0.07 – 0.0425 = 0.0275 i.e. 2.75%.

r = (1 + 0.07) / (1 + 0.0425) – 1 = (1.07 / 1.0425) – 1 = 1.026379 -1 = 0.026379

Change the magnitude (increase/decrease) of the expected rate of inflation by 1 percentage point i.e. ∆Pe = + 1%.

∆Pe = + 1Pe = 4.25% + 1.00% = 5.25%; thus

r = (1+ 0.07) / (1+ 0.0525)-1 = 0.0166 i.e. 1.66%.

ACST101 Tutorial Solutions Topic 1 (to discuss in week 2 Tute) 2018

If you are a borrower and your loan interest rate is ‘fixed’, you would prefer that actual inflation is greater than anticipated as you will be paying back the loan in dollars that have less buying power than those you received when you took out the loan. The opposite is true for the lender in this situation.

NOTE: if either r or ∆Pe (or both) are relatively small magnitudes the simplified Fisher equation provides a close estimate of the exact Fisher equation .relationship.

Price, Value and real returns (20 minutes)

4. Consider the property sale and rental history for 39 Post Office St Carlingford.

Source: On the house: http://www.onthehouse.com.au/for_rent/1585380/39_post_office_st_carlingford_nsw_2118?status=for- rent&stateCode=NSW&suburb=Carlingford&postCode=2118&soldHistory&rentedHistory&types=House,Duplex,Duplexsemi- Detached,Semi-Detached,Alpine,Acreagesemi-Rural,Retirement

Realestate.com https://www.realestate.com.au/property/39-post-office-st-carlingford-nsw-2118?rsf=syn:oth

2

The property at Carlingford sold in December 2012 at $755,000 and was then rented out at $450/wk.

(Annual rent is $450 x 52 weeks = $23,400. So to recoup the cost of $755,000, it takes 755,000/23,400= 32.26years)

The same property sold again in Feb 2014 at $1,220,000. It is now rented out at $510/wk.

How many years will it take to recover the purchase price at this rental?

(Annual rent is $510 x 52 weeks = $26,520. So to recoup the cost of $1.22m, it takes 1.22m/26520= 46.00 years…much longer than in 2012)

a) What was the nominal percentage increase in:

i. ii.

i.

the house price? the weekly rent?

Nominal capital return = (P1-P0)/P0

(Price Feb’14 – Price Dec’12)/Price Dec’12 = (1,220,000-755000)/755000= .6159 0r 61.59% This is the proportionate increase in price.

ii. The weekly rent rose from $450 to $510 per week. This was a nominal

increase of

(510-450)/450= 0.1333 or 13.3%

…nothing in this justifies the increase in house price.

b) If the Consumer Price Index rose from 102.3 to 105.6 in the period Dec 2012 to March 2014, calculate the real percentage increase in the Carlingford house price over the 15 months.

(ABS website: http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/6401.0Sep%202016?OpenDocument) )

We express inflation as a percentage using the rise in the index over the index position at

the start of the period

(March index- Dec index)/Dec Index

= (105.6-102.3)/102.3= 0.0323 or 3.23 % over the 15 month period

ACST101 Tutorial Solutions Topic 1 (to discuss in week 2 Tute) 2018

Approach:

- Use the nominal rate of price increase on the Carlingford property,
- Actual Inflation rate (above)= 0.0323
- Input to Exact Fisher equation:

real return = (1+nominal return)/(1+inflation) – 1

R=(1+0.6159)/(1+.0323)-1=0.5653 or 56.53%

3

Your expectations of yourself in Finance 1A

- What are the average number of hours you expect to spend on ACST101 each week, including the 3 hours spent in the lecture and tute. ___________
- How many online quizzes (out of ten) do you plan to attempt this semester? ___________

(Among the students who failed ACST101 S2 2017, some 85% neglected to attempt all quizzes)