The official cash rate (OCR) is the interest rate that financial institutions charge other financial institutions for overnight loans. OCR is regulated by the Reserve Bank of Australia (RBA), and any such changes in OCR affect Market interest rates as well as rates on housing and other loans. On the other hand, Market Interest rate refers to the interest rate paid for deposits and other investments. Unlike OCR, the market Interest rate is determined by forces of supply and demand for funds in the money market. Again, unlike OCR, the market interest rate is different for different investment vehicles.
The mechanism by which the RBA decreases the cash rate
RBA uses open market operations to regulate the cash rate. This involves exercising control over the supply of exchange settlement funds. Exchange settlement funds are funds used by financial institutions (including commercial banks) to settle transactions with each other. To decrease the cash rate, RBA increases the supply of exchange settlement funds. This leads to an increase of funds held by the commercial banks/financial institutions and stimulates commercial banks to reduce their cash holding by lending more to the cash market. This ultimately results in a decrease in cash rate as banks accept a “lower return” in an attempt to win more customers and to undercut other lenders (Hall and Taylor 1993).
Effects of a fall in the interest rate on consumption and investment expenditures
Most business investment expenditures, as well as household consumption expenditures, are settled using borrowed money. Thus, a decrease in interest rate “translates to an increase in borrowing” used for consumption and investment expenditure (Miller and Benjamin 2004).
Therefore, a fall in interest rate will trigger an increase in aggregate expenditure, and the aggregate expenditure line AE will shift upwards to AE’.
The effects of a decrease in the interest rate on the level of aggregate demand
Aggregate Demand (AD) represents “total demand for goods and services” in an economy at various price levels (O’Sullivan and Steven 2003). Price levels are in turn influenced by the interest rates. AD is a downward sloping curve because at lower price levels more goods and services are demanded.
Thus, a decrease in interest rate will cause an increase in investment spending and as a result, the Aggregate Demand curve AD will shift to the right to AD’.
How to fall in the interest rate affect the inflation rate and the unemployment rate
Long-term fall of interest rate will lead to more money in circulation which will force an “upward pressure on prices” (Abel and Bernanke 2005). This may result in an increase in the rate of inflation due to a situation described as “too much money chasing too few goods”.
On unemployment, the increase in aggregate demand for the country’s output due to a “fall in interest rate will lead to increased production” and result in the creation of jobs (Baumol, William and Alan 2006).
Contractionary monetary policy consists of open market operations such as selling securities, increasing reserve requirements, and increasing discount rates. The resulting decrease in money supply forces commercial banks to slow their credit creation process. This leads to an increase in interest rates and a decrease in aggregate expenditure, and hence a reduction in inflationary pressures.
Expansionary monetary policy, on the other hand, involves buying securities, lowering reserve requirements, and lowering discount rates. This results in an increase in the number of reserves held by commercial banks and consequently commercial banks are “inclined to increase credit creation by lending more at lower interest rates” (Mishkin and Frederic 1995). Both tools (expansionary and contractionary monetary policies) are used by RBA to regulate the amount of money in circulation by controlling the interest rates.
Abel, A. and Bernanke, B., 2005. Macroeconomics, 5th ed., New Jersey: Pearson Prentice Hall.
Baumol, William, J. and Alan, S. 2006. Macroeconomics: Principles and Policy, 10th ed., South-Western: Thomson.
Hall, E. and Taylor, B.1993. Macroeconomics, New York: W.W. Norton.
Miller, R. and Benjamin, D. 2004. The Economics of Macro Issues, Boston: Pearson Prentice Hall.
Mishkin and Frederic, S. 1995. The Economics of Money, Banking, and Financial Markets., New York: Harper Collins.
O’Sullivan, A. and Steven, M. 2003. Economics: Principles in action, Upper Saddle River-New Jersey 07458: Pearson Prentice Hall.