Explain the difference between the official cash rate and the market rate of interest. Explain the mechanism by which the RBA decreases the cash rate. Use diagram(s) in answering the question.
The Global Economy
Answer to Q-1
When a person (borrower) takes a loan from the lender and the lender for the use of that money charges the interest, that interest rate is known as Market interest rate. Interest rates are calculated on the percentage of the principal amount. Cash rates are no different from market interest rate, but cash rate are the rates which are charged by the financial institutions for a loan or pay for a loan taken from the market. (Romer, 2011, pp. 324-25)
To reduce the inflation rate or to low it and for sustainable economic growth, governments often introduce some policies to control the monetary and financial conditions and the policies introduced by government are known as monetary policy.
The central banks use the monetary tools or open market operations to alter the supply of funds so that they can control the rate of inflation and at the same time strive toward achieving a balance between growth and inflation. It has been concluded and accepted that some inflation is both good and necessary for economies to grow. Inflation is considered to be better than deflation. However, if inflation gets out of control, it is important for the authorities to participate in the markets and check the rate of inflation to sustainable levels.
There are two ways in which monetary policies are implemented in the market.
Firstly, when monetary policies are modified by the Reserve Bank or the government, the new standards for the Cash Rate are defined because these rates do effect the market operations of bank. The cash rate sets the standards for the banks to carry out their activities according to the cash rate.
Secondly, then banks begin to participate in the market activities to control the cash rate at its standards by trading of securities. The Reserve banks buy or sell govt. bonds to increase or decrease liquidity in the markets or the flow of money on the markets. These actions of banks are known as open market operations. Such steps are been taken by the banks so that a proper demand and supply balance can be maintained. (RBA, 2012)