Posted: November 30th, 2013
The official cash rate, also called the cash rate target is the accrual rate that banks pay in Australia’s nightlong money market. The cash rate target can only be changed by business undertakings between the central bank and a financial institution. Money supply is not affected by proceeds between financial institutions as this only changes the location. Market rates of interest are accrual rates paid on cash deposits or other ventures. This rate is resolved by the supply and demand of credit in the money market (Jackson et al., 2011).
The difference between the two is that the official cash rate is set by the central bank, in this case the Reserve Bank of Australia while the market interest rate is determined by the economic forces of supply and demand. The set official cash rate governs the availability of government issued securities such as bonds through their sale or purchase, which affects the supply or demand of money and, consequently, the interest rate. The effect of changes to the official cash rate can be reflected in the changes in the rates on loans lent by financial institutions.
The Reserve Bank regulates the cash rate by first setting an objective. It uses the cash rate as a means of regulating the economic growth of Australia by adjusting it since the cash rate has a significant influence on the economy. The Bank accomplishes this by making appraisals of the economic outlook of the country and recommendations are sent to the Board that meets monthly to review the cash rate target. The second way is by the Bank undertaking business dealings set to either increase or decrease the demand and inversely the supply of cash. This is done through certain instruments like bonds and securities (Campbell, 2007).
The interest rate is a monetary policy tool used by central banks such as the Reserve Bank of Australia to control certain economic variables like inflation. A decrease in the interest rate would lead to added incentive for borrowers to loan money from financial institutions. This increases the supply on money in the economy and ideally leads to increased expenditure especially on consumer goods. This is evidenced by the time preference theory since people prefer having goods now as compared to a future date. Similarly, a decrease in interest rates would provide an incentive for investors to borrow money from banks and other financial institutions
A greater money supply is associated with a decrease in the interest rates. Supply and demand have an antagonistic relationship in that an increase in supply translates to a decrease in demand and vice versa but only as far as elastic goods are concerned. A decrease in the interest rates would increase the aggregate demand in an economy, owing to the increase in the consumers’ purchasing power due to the increased money supply.
An increase in the money supply increases the probability of an inflationary effect on the economy. The quantity theory of money relates in supply of money in an economy to the price levels of commodities. This results in inflation, which is a steady ascent in the cost of commodities leading to a specific amount of money buying fewer goods with time. The easier accessibility to loans by investors leads to increase in the supply of goods. To maintain the profits supply is curtailed to increase demand and with it the prices of the goods.
As a major determinant of investment, a decrease in interest rates can stimulate an increase in investment opportunities. Investors in turn set up businesses in the economy. This leads to an increase in the output, which gives the business more mandates to increase the supply. More businesses mean more jobs created, therefore, leading to a fall in the unemployment rate (McTaggart, 2007).
Credit creation is the process that leads to changes in money supply. In commercial banks, the mode used to create credit is called fractional reserve banking. This entails a bank keeping a reserve of the consumers’ deposits. Deposits at a bank are normally lent out, but the bank withholds a fraction to counter its customers’ liabilities. Fractional reserve banking is a vehicle through which the money supply can be increased since bank deposits are treated as money. Commercial banks are, therefore, said to have created money. Fractional reserve banking guarantees that the broad money supply is a multiple of the foundation currency generated by the central bank.
Fractional reserve banking works on the tenet that money deposited by a customer is considered a loan to the bank, and it becomes the bank’s liability in its books. Cash reserves at the bank are only a percentage the bank owes depositors because it also loans money to borrowers. Money is created by banks lending among themselves, and the fractional reserve serves to set limits to the money supply in the economy. Depositors are assumed not likely to make withdrawals simultaneously, as this would cause a bank run leading to collapse. Currently that is unlikely because central banks act as guarantors to the commercial bank’s liabilities (Willis 2006).
Expansionary monetary policy seeks to increase a country’s money supply rapidly by decreasing rates of nominal interest, offering a discount window on loans or extending loans, lowering the set reserve requirements and increasing the monetary base. The monetary authority acts as a regulator to commercial banks and implements these tools to moderate a country’s economic situation. It seeks to counter the effects of recession such as unemployment by giving investors incentives such as easy credit to expand business (Campbell 2007).
This monetary policy works with respect to the credit creation process by banks being allowed to have lower fractional reserves than usual. This implies that banks have increased funds to lend out to investors, and the money supply is increased in the economy. Money supply affects economic variables such as unemployment by decreasing them. Investors create jobs in the economy when they have access to capital (loans from banks). This stance is debated due to ramifications of other economic variables and the side effects that it poses such as inflation.
Money supply affects aggregate demand, which is the demand for goods and services at a given time in the economy ant at a certain price level. Increase in the money supply afforded by an expansionary monetary policy pushes the aggregate demand curve/slope outwards. In real economies, the shift in aggregate demand curve indicates that the prices of commodities increase when the money supply is increased. If unchecked such a situation often leads to inflation due to the higher spending occasioned by an increased money supply. This is called the Keynes’ effect (Garnett 2010). The Reserve Bank has several instruments at its disposal to monitor the economy.
Campbell, F 2007, The implementation of monetary policy: domestic market operations, Reserve Bank of Australia, Sydney.
Garnett, A 2010, Economics, Pearson Choices, Frenchs Forest, N.S.W.
Jackson, J, Mciver, R & Wilson, E 2011, Macroeconomics, McGraw-Hill, North Ryde, N.S.W.
McTaggart, D 2007, Economics, Pearson Education Australia, Frenchs Forest, N.S.W.
Willis, IR 2006, Economics and the environment, Allen and Unwin, Crows Nest, N.S.W.
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