Factors Considered in Determining Interbank Interest Rates - Example

Economic report Name Institution Course Date Introduction The report brings an analysis of an article that concern with cut rates by RBA. Policy instruments are defined as the available options that can be utilized by the government to run economic activities. Instruments are classified as either monetary policy or fiscal policy. Fiscal policy refers to those actions undertaken by the government in relation to its level and composition of expenditure, borrowing and taxation with the main objectives being to spur economic growth, lower unemployment rate, manipulate growth and level of output and aggregate demand. Monetary policy refers to the actions pursued by the central bank of a country to regulate the amount of money supply in the economy. The actions can be either on interest rates or on exchange rates. The main objective is to check on the rate and level of expansion of AD (aggregate demand) in the nation. Specifically it is used to control the rate of inflation and unemployment rate. Monetary policy can classified as expansionary or contractionary policy. Therefore, a target is also referred to as an objective. It is the aim of any economic policy and it can be measured in reference to an economic variable like unemployment rate, growth of Gross Domestic Product (GDP), or rate of inflation. To achieve these targets we use policy instruments. A change in economic policy (instruments) used will led to a change on the other variable (the target). This indicates of the relationship existing among economic variables1. The expansionary monetary policy has a positive effect on the challenges that an economy is going through in a sub-prime crisis. The challenges include low growth rate and skyrocketing interest rates. The policy will reduce the interest rate which is a recipe for increased capital investment, hence an improvement in economic growth. The use of discretionary monetary policy is suitable for the reserve bank of Australia in control of the prevailing economic crisis. The result of a sub-prime crisis is ballooning inflation rates; the households find it difficult to meet their daily needs. To reduce the high inflation rates, which are closely related with the deficiencies within the financial sector, is to adopt monetary policies that are geared towards reducing the interest rates and stability of commodity prices. Factors considered in determining interbank interest rates The main objective of Australian government is to boost economic growth. Therefore, the country policy makers will have to adopt a growth targeting monetary policy. Under this monetary policy, the target is to improve economic performance. The growth target can only be attained through the central bank periodical adjustment on the interest rate target. The economy will adopt an expansionary monetary policy where the amount of money supplied in the economy is increased through interest rates cut leading to growth and increased investment. The changes made on the interest rate target occur in response to a number of market indicators in an effort to foretell economic patterns. This will ensure that the key objective of an economic growth target is achieved. When cash rate is lower than the expected, the commercial banks are likely to increase interest rates. This is an expansionary policy since it will ensure a just economy and a low interest rate. The other factor used by RBA to determine interbank interest rate is economic performance. Australia’s economy is recorded as one of the strongest and fast growing economy in the world. In the last decade, the economy has recorded a fall in unemployment and economic growth. With the economy, engaging in vigorous policy and structural reforms the economy has turn out to be resilient, flexible and well integrated with worldwide markets. In the recent years the economy has be able to overcome both internal and external milestones such as a housing boom, major drought and the economic and financial crisis that had hardly hit the Asian community. The market forces determine interest rates and as such, the economy faces the risks of uncertainty because prices fluctuate on a daily basis. Therefore, it brings confusion among importers and exporters since they are not sure of the exact price. In addition, it may act as an impediment to investment, and the economy is at risk of lacking investment both internal and foreign investment. The other risk is that an economy is vulnerable to high inflation rates, and as a result, an economy will face adverse economic times. Furthermore, an economy will be exposed to the risks of speculation; this will destabilize and damage the economic performance of the country. An economy will also face the risks of mounting deficits in relation to balance of payment deficits. As such, the RBA use the prevailing conditions in the market in order to determine interbank interest rates. Reasons Given By Banks for Not Matching the Interest Rate Cuts The chief reason provided by Australian banks is profits protection. The commercial banks increased interest rates in order to protect profits. They maintain that during the global financial crisis commercial banks incurred high borrowing costs. Commercial find the interest rates charged on borrowers as appropriate since it cushion their profit. Australians banks faced high total funding costs because most of their funds are sourced from overseas. The competition among banks in Australia in seek of new borrowers, as well as the uncertainty of lending money during global economic crisis affects the funding costs of local banks. Uncertainty in the global environment is another reason given by local banks. Local banks in Australia still nurse the effects of the global financial crisis, and they fear a repeat of the same may adversely affect their operations. In addition, banks in the global market are still undergoing difficult times, and as such, it will make local banks overseas borrowing costs to increase. The basis of determining lending rates is also another reason for banks not to match their interest rates with those of RBA. Despite banks using that changes in RBA's cash rate as a basis for setting corporate borrowing rates, they also link the loans other money market rates and bond prices or fixed rates. As a result, customers on market rates benefit when the rates decline, even early than the move taken by RBA. Therefore, the move to pass on rates changes should not be blanket-like, but in relation to loans that are referenced to the reserve bank of Australia cash rate. Whenever there is a cut on interest rates, commercial banks should pass on the changes in rates to the public. The treasurer should ensure that rate cuts are passed to the public in full. This is because local banks should be forced to adhere to new changes, otherwise consumers may not benefit from interest rate changes. On the contrary, when interest rates are increased by RBA, commercial banks pass on the increase in full to consumers, but when the rates are lowered borrowing costs for banks is not affect because they source more than one-thirds of their lending money from overseas2. When the rates of interests declines, the businesses will have an incentive to borrow money to expand their businesses unlike when the interest rates are high. This is because the amount of interest attracted by the principal amount will be very low hence cannot squeeze the business of its profit. Normally the decrease in interest rates is caused by an increase in government spending which we said earlier it’s a recipe for high investment in a particular sector. It is important to note that when the government spending decreases, the interest rates will be high. This to a greater percentage will discourage businesses from borrowing money. The multiplier effect will be minimal because the amplified incomes are less. This means that the amounts of money in circulation will reduce hence no extra money to be invested. This affects the entire economy in a big way. The various stakeholders have to be very careful when dealing with such situations. It will be hard for businesses to find additional money to expand their venture. In the entire economy, everything will be tight because the aggregate demands also will drops. This indicates that the amount of goods demanded is minimal beyond the expectations and the normal level in the economy. This is an impediment to the development of industries. When the purchasing power of consumers is down the investors will tend to limit extend of their investment or even decline to invest at all. Conclusion The use of interest rate cuts as a monetary policy by RBA is the best action in ensuring economic growth and increased investment. However, the move cannot achieve its intended objective because of interest disparity between RBA and local banks. Banks fail to pass on the change in interest rates to consumers. It is essential for the economy to use other actions such as political reforms in order to achieve the intended objective of economic growth and increased investment. In addition, it will increase consumer confidence because of minimal uncertainties. Commercial banks should match their lending rates with cash rate in order to protect consumers from high cost of borrowing and living. Bibliography Staff reporter. RBA cash rate cut ups pressure on banks. Retrieved from http://www.businessspectator.com.au/bs.nsf/Article/RBA-cuts-cash-rate-by-05-bps- pd20120501-TV6XG?OpenDocument&src=tnb Read More