The Difference Between the Official Cash Rate and the Market Rate of Interest
The Official Cash Rate (OFC) can be defined as the interest rate that gets charged between financial intermediaries, on overnight loans (Lien, 2009). OFC relies on the general supply of cash, or else deposits, in the short-term money market which, sequentially, becomes controlled by the Reserve Bank of Australia (RBA) during its market processes. Hence, OFC must have a close association with existing marketing interest rates.
On the other hand, the market rate of interest is the interest rate that arises from demand and supply of loanable funds (Arnold, 2008). This interest rate can, also, be referred to as the nominal interest rate, and it is never the actual cost of borrowing, since part of it mirrors the projected inflation rate.
The Mechanism by Which the RBA Decreases the Cash Rate
If RBA wants to reduce interest rates, it has to declare a lower cash rate target while giving the motives behind this decision. So as, to achieve this target, the RBA has to repurchase government securities from institutions of finance working in the overnight money market.
The buying, by RBA, would make the fee paid, for securities, to enlarge, thus, decreasing their yield, so that institutions of finance would be eradicating them, joyously. After this happens, deposits become shifted from the RBA to institutions of finance, in trade for government securities. This boosts the supply of cash or the amount of deposits in custody of financial organisations, in their exchange settlement accounts, making the market contain surplus funds (shown in Fig 1). Besides, this results in a decrease, in the cash rate towards the preferred RBA mark. Lower rates become declared when economic action is weak and typically, mirror a clear stance of monetary policy.
The Effects of a Decrease in the Interest Rate
A decrease in the interest rates accelerates AD. This occurs because lower rates dispirit saving and support credit- sensitive C and I spending, which depend on borrowing. As a result, this tends to trigger retail sales to increase and stocks to decrease.
Institutions should react through stimulating production (GDP) and recruit more resources, such as, labor. The RBA approximates that a 1% decrease, in the cash rate, assist in boosting economic growth, in GDP, by about 0.8 %.
A decrease in domestic interest rates, in relation to interest rates of other countries, leads to a decline in RBA’s interest rates, as seen between 2001 and 2002. This is partially because there is additional, capital outflow from Australia looking for enhanced returns in a different place. This causes augmented sales of the Australian dollar, making the rate of exchange deflate. Consecutively, AD increases because of exports becoming more essential compared with imports (Arnold, 2008). Also, this is useful in encouraging economic activity, in a downturn, thus assisting to develop domestic, economic stability.
The RBA may also emphasise expansionary interest rate decreases, so as, to arrest a downturn, through using two other little significant actions. First, because the exchange rate is excessively high, hypothetically, the RBA may weaken the currency a bit through trading the dollar in the foreign exchange market by means of a “dirty float” (Taylor, 2000). As a result, a lower exchange rate would be apt to kindle exports compared with imports, thus, intensifying AD. Second, the RBA can utilise its persuasion power to promote further lending by the financial segment, and through painting an optimistic portrait. Such persuasion can enhance domestic stability and aid in recovery.
The monetary policy can at times encourage domestic stability through escalating AS (Taylor, 2000). Whereas monetary policy is principally a macroeconomic gauge, which controls AD and lessens the severity of the business phase, it can, as well, have impacts on the supply aspect of the economy. For example, if RBA had decreased interest rates following inflation, between 1996-1999 or 2001–2002, it would have decreased costs of productions, developed competitiveness, and reinforced company profitability. These companies would have developed their operations and be less apt to decline. Therefore, structural unemployment would have been low, resulting in an external budge in productive capability.
The AD–AS diagram below (Fig 2) demonstrates the budge in productive capability, from AS1 to AS2. Besides, the diagram demonstrates how equilibrium happens at an elevated height of GDP, from GDP1 to GDP2 and at a reduced height of inflation, from P1 to P2. Domestic economic stability becomes enhanced.
However, it is not always feasible for the RBA to decrease rates of interests in this approach. Occasionally, the RBA becomes impelled to raise interest rates, in order to slow inflation of demand (Arnold, 2008). In such circumstances, the policy would contribute to advanced costs of production, business terminations, structural joblessness, and an inner change in the AS, which denotes a decline in productive competence with a change from AS2 to AS1.
By decreasing rates of interest and assuming a more expansionary bearing that motivates spending, monetary policy can aid decrease cyclic unemployment and enhance equity. Households and Companies boost their borrowing and spending, due to reduced rates of interests (Lien, 2009). Consequently, this elevates employment, state production and incomes. Also, decreasing interest rates, on the supply-side, is likely to alleviate cost pressures, enhance profitability, and promote business growth and consequences reduced closures of industries.
This aids in reducing structural unemployment. RBA’s policies have lately helped to reduce unemployment to its lowest height (4.4%), in about 32 years. Also, the monetary policy has aided in enhancing equity, through encouraging domestic stability (Taylor, 2000). By maintaining low levels of unemployment and inflation, RBA has boosted the real purchasing power of the deprived, in the society.
References
Arnold, R 2010, Economics, Cengage Learning, London.
Lien, K 2009, Day trading and swing trading the currency market: technical and fundamental strategies to profit from market moves, John Wiley & Sons, Inc, Hoboken.
Taylor, J 2000, ‘The role of the exchange rate in monetary policy rules.’ American Economic Review, vol. 91, pp. 263-267.