The Official Cash Rate and the Market Rate of Interest

Explain the difference between the official cash rate and the market rate of interest

The official cash rate corresponds to the interest that other banks pay to the reserve bank in the over-night market. The rate applies to exchange settlement accounts that other banks hold with the central bank. Using the rate, the Reserve Bank of Australia (RBA) has the capacity to adjust interest rates that individual banks charge their clients. This way, RBA can control the economy of the country. The rate is only affected when the central bank transacts with other financial institutions. On the other hand, the market rate of interest is the prevailing percentage that banks and other financial institutions charge their customers. The rate is reflected in mortgages and other loans, as well as in savings.

The official cash rate is determined through a board sitting where the board agrees to the figure based on the financial policy they are pursuing. This usually follows analysis of the economic trends. The market rate differs from the official rate in that it is dependent on the market conditions governing demand and supply. Changes in the official cash rate affect the market rates in short durations. The ability of the central bank to control interest on borrowing and lending allows it to control the rates of inflation (Choudhry 2010, p.234).

Explain the mechanism by which the RBA decreases the cash rate

When deciding the official cash rate, the reserve bank must first analyze the trending market conditions. The board uses available information concerning inflation and output levels. When inflation rate decreases, the reserve bank decreases the official cash rate. RBA buys government bonds and other securities from the financial institutions. This causes the institutions to gain after selling the securities. This in turn increases their liquidity. In an effort to attain their target balance, the institutions lower their lending rates in order to lure customers (Basdevant 2005, p. 7).

Three stages of RBA
Three stages of RBA

Analyze the effects of a decrease in the interest rate on consumption and investment expenditures, the level of aggregate demand, the inflation and the unemployment rates

When the interest rate decreases, it triggers the consumers to borrow more increasing the rate of consumption. With increased borrowing power, customers are able to budget for higher capital expenditures. The net effect is an increase in the amount they are willing and ready to invest. Customers borrow more from the bank institutions to take advantage of the low borrowing rates and consequently, an investor is empowered to purchase expensive equipment. The household sector gets empowerment to purchase domestic products that enhance their standard of living. On the other hand, the business sector is empowered through the borrowing power to increase their investment by expanding their facilities or purchasing capital equipment (Mankiw 2011, p.460).

A change in interest rate consequently leads to change in the price level. A lower price level as a result of lower rate of interest encourages borrowing. This induced borrowing corresponds to an increased rate of investment and a corresponding increase in domestic consumption. Increase in the rate of investment and consumption consequently causes the rate of aggregate demand to increase. The interest rate, therefore, directly affects the aggregate demand (Mankiw 2011, p.460).

Decrease in interest rates provides an atmosphere for more borrowing. Low rates allow borrowers to have more money to spend. People tend to spend more. Consequently, the demand for goods and services experience a sharp increase. This causes the rate of inflation to increase (Mankiw 2011, p.460).

When the rate of interest is low, investors borrow more to invest in their businesses. This forms an incentive for economic growth. A growth in economy means that the business sector can employ more people as they expand thereby reducing the rates of unemployment (Mankiw 2011, p.460).

Explain what is the meant by the credit creation process of the commercial banks and how it may be influenced by the expansionary monetary policy

Credit creation starts when an individual bank lends out its primary deposits. Primary deposits include cheque or cash deposits by customers. Out of these deposits, the bank is able to give loans or advances to its customer base. A bank can also raise its deposits through procurement of government securities or discounting bills. When a customer requests for loan, the bank opens an account under the customer’s name and credits. The bank, therefore, lends money in terms of deposit credit. The banking system as a whole may synergistically create credit through multiple-expansion. The process of credit creation is however limited by various factors. First, the cash reserve ratio. A bank is not authorized to use all the deposits to offer credit. The institution must retain a percentage of deposits as cash reserve. If the ratio to maintain is high, the bank reduces the amount of credit on offer and the converse is true. Secondly, the amount of cash deposit available. The more the cash a bank receives, the more it can offer in terms of credit (Somashekar 2009, p.18).

Expansionary monetary policy aims at lowering the interest rates. This would in turn encourage borrowing for investment by the business sector. Increased investment encourages economic growth. The expansionary monetary policy encourages the process of credit creation by maintaining low interest rates to encourage borrowing. This has the consequence of increasing the rate of investment and, thereby, lowering the rate of unemployment. The central banks do this by giving discounts on bonds so that the banks retain more money which can be used to offer loans. When the banks have more float, they reduce the borrowing rates to encourage investors to borrow (Mishkin 2007, p.10).

References

BASDEVANT, O. (2005). Monetary policy in transition, Nova Science Publishers. New York

CHOUDHRY, M. (2010). The REPO handbook, Butterworth-Heinemann, Oxford.

MANKIW, N. G. (2011). Principles of economics, Mason, Thomson South-Western, Ohio.

MISHKIN, F. S. (2007). Monetary policy strategy, Mass. [u.a.], MIT Press, Cambridge.

SOMASHEKAR, N. T. (2009). Banking, New Age International, New Delhi.

Theory 1 – Theories – Monetary Policy Committee – Monetary Policy – Economics bank – Virtual Bank of Biz/ed, Web.