Sunday, 12 August 2012

the cash rate

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The official cash rate is an overnight interest rate and is the Reserve Bank of

Australia’s (RBA’s) key monetary policy lever. The RBA conducts open market

Operations (buying and selling Commonwealth government securities) to maintain the cash rate at its pre-specified target level.

All other money market and bond market rates are related to the cash rate after allowing for maturity risk, credit risk and interest rate expectations.

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The cash market is a market for the deposit and lending of funds overnight. Banks, financial institutions and large companies will deposit any surplus cash in the market in order to earn interest.

The interest rate on these funds (i.e. the cash rate) is determined by the demand + supply for funds.

The demand for cash is determined by the reserves of cash (exchange settlement funds) held by banks in their Exchange Settlement Accounts (ESAs) with the Reserve Bank.

These funds are used on a daily basis by the banks in settling transactions between themselves. The Reserve Bank stipulates that these accounts must not be overdrawn (and pays nominal interest on them), so banks typically keep reserve balances in their accounts to meet unexpected requirements for cash.

The supply of cash in the short-term money market is determined by the Reserve Bank. It has monopoly control over the supply of cash. Settlement of debts between commercial banks does not change the supply of cash, only the balances in each bank’s Exchange Settlement Account. The supply of cash will only change when the Reserve Bank makes a payment to a commercial bank’s ESA or a commercial bank makes a payment to the Reserve Bank.

For example � payments of taxation to the Commonwealth government by the banks will lead to a rundown in ESA balances and the supply of cash will decrease unless the Reserve Bank injects more cash into the system to maintain the cash rate at its current level.

The Reserve Bank controls the volume of cash through its market operations. Purchases of existing Commonwealth Government Securities (CGS) by the Reserve Bank will lead to a rise in the supply of cash when payments are made into a bank’s ESA.

When the Reserve Bank sells CGSs commercial banks will withdraw funds from their ESAs and make payments to the Reserve Bank, reducing the supply of cash in the market.

The Commonwealth government’s budget outcome is also fully financed through the issue of bonds so that there is no need for the Reserve bank to ‘print money’ to finance any budget deficits.

In the above figure it illustrates what would happen to the cash rate if the RBA wanted to ease or tighten monetary policy using market operations. If the Reserve Bank wanted to tighten the stance of monetary policy because of fears over rising inflation, it would conduct market operations to achieve a shortage of cash in the cash market.

If the Reserve Bank wanted to achieve an easing in the stance of monetary policy it would create a surplus of cash in the cash market. This could be achieved through buying existing CGS by making cash payments into banks; ESAs.

This would lead to an increase in the supply of cash (S to S ) relative to demand and cause a fall in the cash rate from r to r .

These changes in the cash rate only occur when the Reserve Bank alters the stance of monetary policy. Changes in policy are announced to the cash market when the Reserve Bank states its dealing intentions and target for the cash rate.

Monetary policy refers to actions by the Reserve Bank of Australia (the federal government’s principle monetary authority) to influence the supply and cost of credit in the economy. The main tool of monetary policy is the Reserve Bank’s use of market operations (the buying and selling of Commonwealth Government Securities or CGS) to influence the official cash rate or interest rate paid on highly liquid deposits in the cash market or short term money market.

By influencing the official cash rate, the Reserve Bank of Australia (RBA) is able to indirectly affect the term structure of interest rates in the financial system, which in turn will affect the level of spending, output, inflation and employment in the economy.

The Reserve Bank has an operating target % to % CPI inflation over the economic cycle and uses monetary policy to achieve this objective.

economics by tim riley

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