Question 1: What is the difference between the official (target) cash rate and the market (actual) rate of interest?
Explain the mechanism by which the RBA reduces the cash rate. Use appropriate diagrams in answering the question. 6 marks
Answer- Official (target) Cash Rate
The official cash rate may be defined as the interest rate which is fixed by Reserve Bank to meet specified inflation targets. These inflation targets are specified in the PTA or Policy Targets Agreement. Official cash rate sometimes is also termed as base rate. Banks generally pay official cash rate or base rate whenever they take loan from other banks with a maturity period of 1 day.
Also, through buying and selling of bonds i.e. corporate bonds and other government securities, the Reserve Bank can influence the supply chain of money thereby influencing the supply target cash rate. It is observed that a rise or fall in cash rate leads to change in mortgages, loans and savings related interest rates.
It must be noted that Official Cash Rate is mainly used in Australia and New Zealand countries. (Global-rates, n.d)
Market (actual) Rate of Interest
Market interest rate may be defined as the rate of interest offered on cash deposits and it is determined by the duration, amount and demand and supply of deposits.
It is often seen that the deposits which are for longer period attract higher interest rate when compared to deposits made for shorter duration. Similarly, the deposits which include higher amount will attract higher interest rates when compared to the deposits of smaller amount.
RBA or Reserve Bank of Australia reduces cash rate to ease inflation. This reduction of cash rate has a direct relationship with mortgages, loans and savings related cash rates. Thus with higher cash rate the flow of money is limited and hence there will be higher interest rates offered on mortgages, loans and savings.
The above diagram shows the relationship between base rate, Inflation and GDP.
(Market interest rate, n.d.)
Question 2: Analyse, using diagrams, effects of a decrease in the interest rate on consumption and investment expenditures, the level of aggregate demand. 6 marks
Answer: A decrease in interest rate will have a direct impact on borrowing. Borrowing will increase thereby increasing the amount of expenditure incurred on consumption and investment. Thus we can say interest rates and borrowing are inversely related to each other. Higher interest rates induce lower borrowing which ultimately results in lower expenditures on consumption and investment. On the other hand lower interest rate gives an entirely different picture. With lower interest rates people tend to borrow more and accordingly higher expenditure is seen in consumption and investment fields.
Now let us understand what causes change in interest rate. A higher price level often induces increase in interest rates to lower the price level. Similarly, a lower price level will induce lowering the interest rates. Thus, price level and interest rates are directly related to each other where higher price level results in higher interest rates and lower price, price level will result in lower interest rates.
The above diagram clearly shows the relationship between price level and interest rates which ultimately impacts the level of expenditure to be incurred on consumption and investment. (Interest-Rate Effect, n.d.)
For example- There is high inflation in the country (high price level of all goods and services) and reserve bank decides to increase the interest rates. This increase in interest rates will lower the amount of borrowing, thus directly affecting the amount of money available in the hands of people to be spent on consumption or investment.
Question 3: Explain how the credit creation process of the commercial banks may be changed by this expansionary monetary policy. 6 marks
Answer: Expansionary monetary policy may be defined as a monetary policy where reduction in interest rates and increase in the money supply are used to correct business-cycle or say business sustainability related problem.
Thus, expansionary monetary policy aims at increasing the flow of money or money circulation to boost the economy. The main aim of expansionary monetary policy is to prevent business-cycle from contraction and also to address key issues like unemployment.
Now, let us understand how this expansionary monetary policy works. Measures like open market buying of U.S. treasury securities, decreasing the requirements for reserves and decreasing the discount rates are included as part of expansionary monetary policy.
However is often observed that open market operations serve as the primary tool for expansionary monetary policy. Expansionary fiscal policy also supports expansionary monetary policy.
Let us understand what is meant by open market operations.
Open market operations include buying and selling of US Treasury securities with the aim to control interest rates, bank reserves and money supply. Because it is easy to implement open market operations, these are the primary monetary policy tools for Federal Reserve Bank. Also, open market operations are very effective and offer huge flexibility.
(Expansionary Monetary Policy, n.d.)
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RBA Official Cash Rate, Australian Central Bank’s interest rate retrieved March27, 2014 from http://www.global-rates.com/interest-rates/central-banks/central-bank-australia/rba-interest-rate.aspx
Market Interest Rate retrieved March27, 2014 from http://www.businessdictionary.com/definition/market-interest-rate.html
How interest rates affect bond prices and yield retrieved March 27, 2014 from http://www.asx.com.au/education/investor-update-newsletter/201310-how-interest-rates-affect-bond-prices-and-yields.htm
Effect of Lower Interest Rates retrieved March27, 2014 from http://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/
Interest rate Effect retrieved March27, 2014 from http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=interest-rate+effect