RBA and Decrease in Cash Rates - Research Paper Example

RBA and decrease in cash rates Question The Reserve bank of Australia (RBA) has decreased the official cash rate very recently (in November 2, 2011) by 0.25 percentage points and now it stands at 4.50% (Cash Rate Target, 2011, p.1). Economists, investors and the market are expecting that the RBA will further decrease the cash rate in near future. Official cash rate is the rate of interest which is used by the central banks of Australia and New Zealand for the purpose of adjusting the national interest rates.

Official cash rates are interest rates which are paid by the RBA in the overnight money market to adjust the overall national economy’s interest rates. This is the weighted average of two interest rates, one is the interest rate that authorized dealers pay on exchange settlement (ES) loans from the banks which is called the ‘interest rates on ES funds’ and the other is the interest rate that is paid by the dealers on overnight loans in non-ES funds is the secured non-ES funds rate (Rankin, 1992, p.2). The basic difference between the official cash rate and the market rate of interest is that the former is related to the market where the RBA deals with certain dealers of the official markets who have the facility to take loans from the lender of last resort.

But the market interest rate deals with those dealers who belong to the unofficial markets of overnight monetary transactions (Elliott and Bewley, 1994, p.2). RBA has accepted official cash rate as the primary tool of implementing monetary policies. In this context the monetary transmission mechanism has been used by the RBA to reduce the cash rate. This mechanism is used in order to affect the level of output and inflation in the economy through monetary policy. This transmission process of reduction in cash rate increases the monetary base of the economy and encourages investors to invest more in investment projects.

Hence, it raises the level of output and reduces inflation rate (Statement by Glenn Stevens, Governor: Monetary Policy Decision, 2011, p.1). Question 2: The fall in the rate of interest attracts investors to invest in different short-term and long-term investment projects because lower rate cost of taking loans from banks and financial markets. The time dimension of the project, i.e. whether it is for the short-term project or for the long-run project depends on the future expectation about the fall in the rate of interest.

If the investors expect that the central bank will further decrease the interest rate in near future then they will invest more on the long-term investment projects and if they expect that this is only a temporary fall in the rate of interest then investors will invest more in the short-term projects. Lower interest rates encourages more investment, hence more production and finally more consumption. Since aggregate demand is the summation of consumption and investment expenditures therefore lower interest rates increases aggregate demand of the economy.

The fall in the interest rate will raise the aggregate demand and aggregate supply of the economy. If the rate of increase in the aggregate demand is lower (higher) than the rate of increase in the aggregate supply, then the prices of products will rise up (fall) and cause inflation (reduce the inflation rate). The fall in the interest rate encourages producers to producers to produce more and hence, the requirement for labour power rises up and the unemployment rate falls (Elliott and Bewley, 1994, pp.12-16). Figure: Increase in AD and AS due to fall in interest rates Question 3: The credit creation process of the commercial banks of an economy can be affected by changes in monetary policy taken by the central bank.

If the central bank increases (decreases) the rate of interest that it charges to give loans to the commercial banks (called the Repo rate), then the commercial banks are discouraged (encouraged) to take loans from the central bank because it raises (lowers) the cost of loans. Hence, commercial banks provide less (more) loans to private investors and hence, less (more) credit gets generated in the economy. If the central bank decreases (increases) the rate of interest that it gives to the commercial banks when it takes loans from them (called the Reverse Repo rate), then the commercial banks are discouraged (encouraged) to give loans to the central bank because it lowers (raises) the profit from loans.

Hence, commercial banks provide more (less) loans to private investors and hence, more (less) credit gets generated in the economy. The increase (decrease) in the Repo rate or Reverse Repo rate is contractionary (expansionary) policy because it lowers (raises) investment and output. The RBA would adopt this expansionary monetary policy of lowering interest rate in order to increase the volume of investment in the economy and to raise the aggregate demand for goods and services and the overall employment level in the economy (Elliott and Bewley, 1994, pp.19-21). References: 1.

Cash Rate Target, (2011), Reserve Bank of Australia, available at: http://www.rba.gov.au/statistics/cash-rate.html (accessed on January 17, 2012) 2. Elliott, G. and Bewley, R. (1994), The Transmission of Monetary Policy: The Relationship between Overnight Cash Rates, Economic Record, Vol. 70, available at: http://www.questia.com/googleScholar.qst?docId=5000227374 (accessed on January 17, 2012) 3. Rankin, B. (1992), THE CASH MARKET IN AUSTRALIA, Reserve Bank of Australia, available at: http://www.rba.gov.

au/publications/rdp/1992/pdf/rdp9214.pdf (accessed on January 17, 2012) 4. Statement by Glenn Stevens, Governor: Monetary Policy Decision, (2011), Reserve bank of Australia, available at: http://www.rba.gov.au/media-releases/2011/mr-11-28.html (accessed on January 17, 2012)