Difference between the Official Cash Rate and the Market Rate of Interest
The official cash rate is the rate that financial institutions charge one another for overnight lending (loans) within the Australian banking system. Changes in official cash rate results in changes in other rates including the market rate of interest. On the other hand, the market rate of interest refers to the prevailing rate of interest in the market that commercial banks charge on loans. The market rate of interest is determined by the loan duration, quality of collateral offered, and the forces of demand and supply. A longer loan repayment period attracts a higher interest rate; similarly when the collateral with a higher quality attracts a lower interest rate.
Mechanisms by which the RBA Decreases the Cash Rate
Given the floating exchange rate regime in Australia, the Reserve Bank of Australia does not directly determine the cash rate; instead it makes use of the tools offered by open market operations to manipulate the cash rate. This in turn affects the whole banking system in such a way that a decrease in the cash rate consequently results in a decrease in other interest rates throughout Australia. In using the open market operations, the RBA capitalizes on its control over money supply that the financial institutions and banks rely on in settling transactions with each other (exchange settlement funds).
If the RBA considers it necessary to reduce the cash rate, it pursues an expansionary monetary policy by increasing the money supply (Christiano, Eichenbaum & Evans 2005, p. 4). The money supply curve LM shifts outwards to the right and the banks are oversupplied with money. The economy attains equilibrium at Y1. Because the banks are now in possession of excess exchange settlement funds, they are forced to increase the amount of loans in the money market; the increased supply pushes down the cash rate as lenders try to attract borrowers by accepting lower returns.
Effects of a Decrease in the Interest Rate on
Consumption and Investment Expenditures
A decrease in interest rate is an incentive to the business segment to increase investment spending. For instance, a one percent point decrease in interest rate from 10% to 9% can result in interest cost savings of approximately AUD 300,000 on an initial loan of AUD 10,000,000 to be repaid over a five year period. This cost savings act as an incentive for companies to undertake additional investment expenditures.
A decline in interest rate is equally likely to convince households to increase their consumption expenditure especially on durable goods. For instance, a one percentage point decrease in interest rate can reduce the interest expense on an AUD 20,000 motorcycle loan by approximately AUD 6,000 within a five year repayment period. The resulting savings in interest expense can convince some households to increase their consumption expenditures.
Level of Aggregate Demand
Aggregate demand is a function of various components: consumption of goods and services (C); Investment (I); government expenditure (G), and Net Exports (X-M).
AD = C + I + G + (X-M). As already discussed, a decline in interest rate affects both consumption and investment expenditure. Consumption expenditure is one of the largest components of aggregate demand. When consumption and investment expenditures increase because of a drop in interest rate, the aggregate demand also increases.
Inflation and Unemployment Rates
Consumer demand is partly determined by the available income that can be used to purchase goods and services. Interest rate has a direct effect on some sources of consumption and investment income. Low interest rates encourage borrowing (reduces the cost of borrowing). Consumers and companies can afford to consume more and invest more respectively. The high levels of consumption and investment boost the demand for goods and services within the economy. This in turn affects output (employment) and prices (Inflation).
As individuals demand for more goods and services because they have the money, producers are encouraged to increase output to capture additional profits. To produce more goods and services companies hire more laborers to produce the goods and services demanded by households and businesses thereby increasing employment (Fxpedia 2012, p1).
On the other hand, low interest rates encourage inflation; low interest rates increase demand for money both for consumption and investment. This puts pressure on the available funds as consumers and business compete for the fixed money supplied, the interest rate increases which in turn increases the cost of borrowing. Businesses transfer the increased cost to the consumers in form of higher prices and consumers pay more for the same bundle of goods. It can be argued that low interest rates encourage inflationary pressures (Svensson 1999, p. 607).
Credit Creation Process of the Commercial Banks and how it may be influenced by the Expansionary Monetary Policy
Credit creation is a process by which commercial banks increase the funds available in their checkable deposits by making use of reserves to create loans. Credit creation is an important process within an economy as it ensures that the government does not take full control over money supply (Somashekar 2009, p.1). Credit creation occurs when a bank issues a loan to a customer or when it buys securities from a seller; the bank does not make immediate cash payments, instead a deposit account is opened in the nake of the seller of the borrower.
The deposit account is then credited with the loan amount granted or with the value of the security purchased subject to cheque withdrawal. The created deposits are often reffered to as derivative deposits that arise from either the loans issued or the securities purchased. The process of credit creation is larglely influenced by the lending and investing opertaions of the bank. A derivative deposit that the bank creates tends to increase demand deposits that the community owns without reducing the currency in circulation and as a result incresaes the available money stock in the community (Bernanke 2004c, p. 1).
As a result, primary deposits perform two functions: it serves as the basis for increasing money supply and credit creation. Given that commercial banks are motivated by profits, they have significant incentive to use any idle cash reserves (primary deposits) to make investments in secuties or advance loans to the public that in turn generate profits in the form of high interest rates. Any amount over and above the reserve ratio required by RBA can be used in credit creation (creating derivative deposits).
An expansionary monetary policy has a positive effect on credit creation. An increase in money supply by RBA adds more liquidity to the banks. The banks use the excess reserves to create more credit. They achieve this by reducing their lending rates to attract more househols and firms to borrow. Although the profitability margin may reduce because of the low interest rate, the large volume of credit offsets the loss associated with reduced interest rate.
List of References
Bernanke, B 2004c, Central bank talk and monetary policy. Web.
Christiano, L, Eichenbaum, M & Evans, C 2005, ‘Nominal rigidities and the dynamic effects of a shock to monetary policy’, Journal of Political Economy, vol. 113, pp. 1-45.
Fxpedia 2012, Australia – Common Economic Statistics – FXPedia. Web.
Somashekar, N 2009, New Age Banking. New Delhi: New Age International Publishers, p.1-10.
Svensson, E 1999, ‘Inflation Targeting as a Monetary Policy Rule’, Journal of Monetary Economics, vol. 43, pp. 607-654.