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Chapter 11:

The Reserve Bank


and interest rates
Presentation prepared
by
Taha Chaiechi
Presentation prepared by
JamesTroy
Cook University
Fuller
andUniversity
Edith Cowan
Martine Mariotti
ANU
John Wiley and Sons
Learning objectives

In this lecture you will learn:


the structure of the interest rate in the
Australian Economy
how the cash rate is determined in the
overnight cash market, and how the RBA
influences the cash rate.
the reasons that central banks focus on
interest rates rather than on money supply.
Structure of interest rate in the
economy
There are different interest rates because
borrowers riskiness differs from one individual to
the next higher interest for higher risks.
Maturity or maturity date: refers to the final
payment date of a loan or other financial
instrument.
Maturity and interest rate relationship: one-
year bank term deposits have shorter term to
maturity and lower risk lower interest rate.
Shorter maturity term always implies lower interest
rate.
90-day bank bill is basically a type of loan among
banks with 90 days to mature.
Cash rate

The cash rate is the interest rate on overnight


loans among banks. For this reason it is
sometimes called the interbank rate.
Cash rate allows the RBA to adjust interest
rates in the economy as deemed required.
Whatever the interest rate, they tend to move
together.
Some key interest rates in the
Australian economy

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The cash market and the cash
rate
Banks lend to consumers, firms and other banks.
The cash market: arrangements for the purchase and
sale of exchange settlement (ES) funds (or balances).
The demand for ES is created by law.
Open market operations: central banks purchase or
sale of government bonds in the open market.
Everyday a lot of cash gets transferred between
banks. For example, your boss may pay your salary
by transferring money from his bank account to
yours. The system that allows this transfer is called
exchange settlement funds.
The cash market and the cash
rate

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Demand for ES funds

Banks hold funds in their ES accounts.


They must make two types of payments:
1. Payment to government or agency (e.g.
taxation)
2. Payment to other banks (e.g ANZ to NAB)
Demand for ES funds

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Supply of ES funds

The cash rate is the equilibrium price in the


market for ES funds.
It is the outcome of the supply and demand
mechanism.
RBA influences the demand for ES and also
controls the supply of ES.
To understand consider the following RBA
balance sheet:
Supply of ES funds

Supply of ES is controlled by RBA through


OMO (open market operation).
The equilibrium cash rate is determined at
the intersection of ES demand and ES supply.
This equilibrium cash rate is the market
clearing rate.
Supply of ES funds

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The RBA and open market
operations
They are undertaken every business day.
The RBA estimates the aggregate net settlement
obligation between the RBA and ES account
holders.
The likely changes in ES balances are estimated for
the day as a result.
If ES balances are expected to fall the RBA
announces an intention to buy securities, and
creates sellers account.
If ES balances are expected to rise the RBA
announces an intention to sell securities, and
creates buyers account.
Equilibrium in the cash market

The RBA sets a target for the cash rate.


To achieve this cash rate, the RBA ensures
the market clears at the equilibrium interest
rate (i0).
At i0, the quantity of ES funds supplied
equals the quantity of ES funds demanded.
The RBA is responsible for the supply of ES
funds at the equilibrium cash rate.
Equilibrium in the cash market

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Equilibrium in the cash market

Now assume the RBA decides to increase its


target for the cash rate.
The RBA must determine the new supply
level of ES funds which is lower than
previous situation.
The new cash rate is again determined by
the intersection of new supply and demand
for ES funds.
The effect of an increase in the
quantity of ES funds demanded
Suppose that the demand curve for ES funds
shifts rightward. If the RBA doesnt change the
supply of ES funds then the cash rate
increases.
But if the RBA decides to keep the cash rate
unchanged then it needs to increase the
supply of ES funds.
Increase in the supply is the shift of the supply
of ES funds to the right by an amount that is
equal to the shift in demand.
Monetary policy target

The monetary policy target is the value of a


monetary variable that the RBA seeks to achieve.
In Australia, the monetary variable is the cash rate.
The RBA has a target value of the cash rate at any
time.
The statistics (since 1994) show that the periods of
high ES balances generally occurred when growth
of credit (bank loans) was slow.
Also periods of low ES balances occurred
historically with strong credit growth.
Credit growth: the rate of the increase in loans of
all kinds across the whole Australian economy.
Monetary policy target

When credit growth is slow, economic activity


tends to be weak which causes the RBA to lower
interest rates by expanding the supply of ES funds.
Hence, the supply of ES funds seems to be high
during low credit growth.
Strong credit growth, on the other hand, occurred
during the five years prior to the global financial
crisis, which coincided with high economic
activities.
This caused the RBA to tighten monetary policy by
reducing the supply of ES funds.
Monetary policy target

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Money supply as an alternative
monetary policy target
Targeting the cash rate is not the only way to
implement monetary policy.
Central banks around the world have adapted
alternative targets and operating procedures in the
past 25 years.
The main alternative is money supply that targets
monetary aggregates.
Central bank first decides on a target for money
supply, and then provides the level of ES funds that
leads to the desired level of money supply (monetary
aggregate).
Cash rate then would then adjust automatically.
Monetary aggregates and
monetary policy
Monetary aggregates include :
M1: all coins and notes held outside RBA +
deposits of non-bank private sector in bank
accounts on which checks can be drawn.
M3: M1 + all other bank deposits of the
private non-bank sector
In the 70s, monetarist economists argued that
by controlling M1, central banks then would be
able to control total income (nominal GDP).
In the 80s the link between nominal GDP and
M1 broke down in many countries.
Monetary policy practices

Central banks tend to control


interest rates to implement
monetary policy.
When the money supply increases,
it will lead to a proportional increase
in the prices (e.g. prices of factors
of production) that is inflation.
Case in point: Credit growth and
nominal GDP

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Summary

By controlling the cash rate, the RBA can


influence the whole structure of interest rates
that borrowers pay and lenders receive.
The cash rate is the interest rate on overnight
interbank loans of ES funds.
The RBA can control the supply of ES funds
which gives it control over the market price
of ES funds (i.e. the cash rate).
Open market operations can be used to
achieve a target for the money supply.

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