Monetary Policy and Effect of a Decrease of Interest Rate - Essay Example

? Monetary Policy Answer one: Official cash rate is that rate of interest set by the Board of the ReserveBank of Australia which is charged on the overnight funds that are borrowed or lent between financial institutions. This implies that it is that rate which is charged by financial institutions in Australia’s banking sector to other banks for overnight loans. This official cash rate is an important monetary policy instrument that influences other interest rates within the market. The RBA often determines the official cash rate after deciding on what monetary policy target it intends to attain (Reserve Bank of Australia, 2012a). Such targets may include, increasing economic growth, lowering inflation. RBA uses open market operations to affect the changes of the official cash rate, which in turn trickles down to the financial system in the country. Although RBA changes the official cash rate through open market operations, the actual cash rates are often determined by supply and demand actions among banks. Each bank is free to determine the rate by which it lends to another bank. Changing the official cash rate however, impacts all other interest rates in the market which in turn impacts the supply and demand of money in the economic system (Reserve Bank of Australia, 2012b; Lowe, 1995:1-2). The market rate of interest on the other hand is the rate that financial institutions charge its clients for borrowing money. This interest is often impacted by changes in the official cash rate, whereby increases in cash rate would imply that the banks are borrowing from other banks expensively and hence would also increase the interest rate that they charge their customers for borrowing money. A drop in the official cash rate would make it cheaper for the banks to borrow funds and hence competition among banks would reduce the market interest rate across the Australian Economy (Smales, 2011:52-55). The RBA decreases the cash rate through open market operations in order to ensure that the official cash rate that has been set is as close as possible to the actual cash rate exhibited in the market due to forces of demand and supply. Each financial institution in the country has an Exchange settlement account for which enable banks to settle payments between each and also with the RBA. Where RBA wants to reduce the cash rate, it would buy repurchase agreements (repos) or second-hand common wealth government securities (CGS) from the financial institutions in the economy. The RBA pays the banks using their exchange settlement accounts with the RBA which increases the amount that they have access to and can lend out (Reserve Bank of Australia, 2012b; Kuttner and Mosser, 2002: 16). This increases the supply of money in the economy, and due to competition to lend out to borrowers, the cash rate as well as the market interest rates drop. This is as demonstrated in a simple Keynesian model below: As noted in the figure, when the RBA uses the open market mechanism to purchase government securities and repos, the money supply denoted by MS, moves from the original position MS to MS1 showing a rise in money supply. Since the supply money is inelastic relative to interest rates, the MS curve is perfectly inelastic. On the other hand, the demand for money changes with changes in interest rate. Hence as money supply increases in volume due to RBA purchasing repos and CGS, interest rates fall also drop. Answer two Effect of a decrease of interest rate on: Consumption and Investment expenditures: a fall interest rates increases investment and consumption. As noted above, a fall in interest rates is as a result in an increase in money supply. This makes it possible for businesses and consumers increase their borrowing from banks at a lower rate of interest since it is cheaper to access loans. Hence, there would be an increase in consumption and investment expenditures financed by debt as businesses are able to access funds for capital goods such as equipments, and consumers are also able to access more money to purchase durable goods such as furniture, house, cars etc (Handa, 2009:313-316). As the figure shows, a drop in interest rate increases the amount of money supply in the economy, which increases real GDP from Y1 to Y2 as output rises, due to increased aggregated investments and consumption expenditure in the economy. Level of aggregate demand: a fall in interest rates increases aggregate demand in the economy. This is because a fall in interest rates reduces the cost of credit in the economy hence consumers can easily access credit, thus increasing the disposable income in the economy which in turn increases aggregate demand for goods and services in the economy, shifting the aggregate demand outward. Where the drop in interest rates is due to price changes, aggregate expenditures often increase along the aggregate demand. Often low price levels in the economy induce the RBA to lower interest rates in order to stimulate expenditure (Walsh, 2010:455). Aggregate expenditure has an inverse relation to price, where a drop in price would increase aggregate expenditure along the demand curve. As money supply rises from MS1 to MS2 due to reduced interest rates, the real GDP in the economy also rise due to disposable income in the economy as people are able to afford more credit from banks. This increases aggregate demand for goods and services in the economy, shifting the aggregate demand outward. Furthermore, a higher demand for goods and services increases the prices of such goods hence increasing prices in the economy. Inflation: a fall in interest rates increases inflation levels. Inflation often refers to persistent rises in prices, or ‘where too much money chases too few goods’ (Handa, 2009:316). When RBA purchases repurchase agreements (repos) or second-hand common wealth government securities (CGS) from the financial institutions in the economy and pays the banks using their exchange settlement accounts, this increases the amount that Banks they have access to and can lend out (Reserve Bank of Australia, 2012; Kuttner and Mosser, 2002:16). This in turn increases the supply of money in the economy. Increase in money supply, increases the price levels as well as the level of output in the economy, and since there is already inflation, increase in money supply further exacerbates inflation levels. However, this view is from a Keynesian view point, where expansionary measures decrease interest rates, which further exacerbates. Hence in reducing inflation, a contractionary monetary policy such as the sale of repos and CGS would increase interest rates lowering inflation due to decreased prices and real output. While monetarist theorists suggest a reduction in money supply in fighting inflation, they differ from Keynesians in that, they argue that reduced money supply decreases interest rates as anticipated inflation rates also decline (Walsh, 2010:352; Handa, 2009:316). Unemployment rates: a fall in interest rates would reduce unemployment in the economy. A fall in interest rate is often due to an increase in money supply from the Keynesian viewpoint, and this increases aggregate demand, investment and consumption expenditures, and output and prices in the economy, which in turn reduces unemployment levels (Handa, 2009:319-321). Increased investment expenditures increased level of business activities and the level of output in the economy, which in turn reduces levels of unemployment. Answer three In the credit creation process within central banks, the cash deposits from the customers serve as the base for creating credit. When a customer deposits a cash deposit say $1000 in their bank accounts, part of this money, say 10%, is deposited with RBA to the exchange settlement account as statutory reserve for meeting the daily withdrawal demands of the bank’s depositors. The remaining amount, $900, is given out as credit. Supposing a borrower A receives the $900 as loan from bank 1, rather than give actual cash, Bank 1 would credit the amount to the borrowers account, say in bank 2. Bank 2 would have now received a deposit of $ 900, where part of this amount 10% is deposited as statutory reserve in exchange settlement account of the bank, and the remaining, $810, is given out as loan to borrower B. If this process of lending and crediting deposits continues, more of credit deposits and money will be available to the economy for use. Hence from the single cash deposit made by a customer, numerous credit deposits have been developed by loans from banks in such a manner that there is more money in the economy. In this sense, the actual cash deposits made by customers serve as the basis of credit creation. Banks are for profit organisations and so when a depositor deposits a large amount of cash, of which such demand deposits are not immediately withdrawn by the depositor, the banks use this either in advancing loans or in investing in shares or securities hence earning a higher interest rate on them (Walsh, 2010: 457, 472). Expansionary monetary policy enhances the credit creation process of commercial banks. With the expansionary monetary policy where RBA buys repos and CGS through the open market operations, the RBA pays for this with bank reserves into the exchange settlement account. The increase in this results to excess reserves which enables the banks to lend out the extra money at lower interest rates, which in turn results to an increase in credit deposits throughout the banking system as well as an increase in money supply within the economy (Walsh, 2010). References Handa, J 2009, ‘Monetary Economics,’ (2nd Edition), Routledge, New York, NY. Kuttner, KN and Mosser, PC 2002, “The Monetary Transmission Mechanism: Some Answers and Future Questions.” FRBNY Economic Policy Review. Accessed 12 September 2012 at: < http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf> Lowe, P 1995 “The Link Between the cash rate and the market interest rates. Research Discussion Paper, Economic analysis Department. Reserve Bank of Australia. Reserve Bank of Australia 2012a, ‘Interest Rate Decisions,’ Accessed 10 September 2012 at: Reserve Bank of Australia 2012b, ‘Monetary Policy,’ Accessed 10 September 2012 at: Smales, LA 2011, "Examining the Effect of RBA Target Rate News on the Interest Rate Futures Market," International Research Journal of Finance & Economics, 81, pp. 51-64. Accessed September 10, 2012 at Business Source Complete, EBSCOhost . Walsh, CE 2010, “Monetary Theory and Policy.” (3rd edition), Cambridge: The MIT Press. Read More