The cash rate is the interest rate in the overnight market for exchange settlement (ES) funds. It is the rate around which all other IR are based on and can be adjusted by the Reserve Bank of Aus (RBA) when it meets on the first Tuesday of every month (except January). At its meeting on March 23rd 2010, it decided to raise the cash rate by 25 basis points to 4%. This is the 4th rise of IR since the Global Financial Crisis (GFC).  The RBA decided to lift the cash rate because a number of economic indicators indicated that economic activity is improving and will continue to do so.

One reason was that the global economy is growing, and world GDP is expected to rise at close to trend pace in 2010/11.  Because of this, many governments around the world are reducing the degree of stimulus to their economies, indicating that the global economy is improving.

Also, the global financial markets are functioning much better than they were a year ago, with support from governments and central banks being gradually wound back. This indicates that governments think that the markets will continue to improve.

The economic conditions in Australia have also improved, with the rate of U/E appearing to have peaked at a much lower level earlier than expected.  Also, lenders are starting to become more willing to lend to some borrowers. Investment in the resources sector sectors is very strong, credit for housing has been expanding at a solid pace, and dwelling prices have risen significantly over the past year.

Also, CPI inflation has risen somewhat recently as temporary factors that had been holding to unusually low rates are now abating. To maintain price stability, the RBA must increase IR to combat forecast rising inflation.

As the risk of serious economic contraction in Australia has passed, the RBA lessened the degree of monetary stimulus last year. This means that the RBA thinks that the economy is in the middle stages of its recovery and past the initial stages, it has raised IR back to a neutral level of 4-5% after bottoming out at 3% in September 2009.

These indicators forecast growth likely to be close to trend and inflation close to target over the coming year, so the RBA has decided it is appropriate to raise the interest rates back closer to a neutral level, and this rise has been a further step in this process.

Transmission Mechanism

A higher cash rate will result have an impact on the following things: economic activity (through consumption & investment), exchange rate, inflationary expectations and on wealth and asset prices.

↑ Cash Rate → ↓C

A rise in the cash rate will increase the attractiveness of saving as it increases the reward for postponing consumption. AS ↑

It also encourages households to defer consumption spending, especially on durables and housing which are sensitive to interest rate changes. AD ↓

Also makes existing borrowers have less liquidity (ie. Ability to convert assets to cash decreases).  Liquidity ↓

Households that don’t owe any money will gain and experience an increase in their income from the higher interest rates paid on their assets. However, if money is owed, a decrease in income will be the resultant effect as they have to repay with a higher interest rate on assets.

If owe: Y↓. If don’t owe or is owed: Y↑

Overall, RBA believes that by tightening monetary policy by increasing the cash rate will cause economic activity to fall, especially because Australian borrowers are highly indebted.

↑ Cash Rate → ↓I

When making investment decisions, firms compare anticipated profits to the cost of borrowed funds needed (interest rates). This is the marginal efficiency of capital (MEC)

MEC =

If MEC > IR, project is viable

As IR ↑, probability that MEC > IR ↓, reducing no. of feasible investment projects.

↑ IR from r1 to r2 → ↓I spending from Q1 to Q2 → AE function decreases from AE1 to AE2 → multiplied ↓ output & U/E from Y1 to Y2. This has an overall effect of decreasing economic activity.

↑ Cash Rate → ↑AUD

High IR encourages inflow of financial capital. This leads to a appreciation of the Australian dollar (AUD).  AUD↑, demand AUD↑

Appreciation of AUD forces price of Australian exports up in world markets, making them less competitive, meaning less people will buy them. X↓

Also leads to fall in import prices, making them more attractive. M↑

X↓ + M↑ → ↓(X-M), ↑CAD, contraction economic activity, ↓output & employment in X & competing industries

The relationship between domestic monetary policy and value AUD is important for policy makers. Effect reinforces ↓AE (C↓, I↓, (X-M)↓)

↑ Cash Rate → ↑inflationary expectations

Spending decisions are affected by perceptions about the stance of monetary policy. Perceptions of likely price stability will be affected by monetary policy actions.

In the past, the RBA has sent out strong messages that it wants to keep inflation down through pre-emptive rises of the cash rate. This causes households and businesses to expect inflation to be on the rise whenever the RBA lifts the cash rate. This causes a decrease in the positive expectations and confidence of households & businesses, making them more unlikely to spend on durables and invest, having a contractionary effect on economic activity.

↑ Cash Rate → ↓Wealth & Asset prices

Rise in cash rate makes shares on the stock market will fall, making them less attractive to investors than bonds. ↓wealth households with share portfolios → ↓C → ↓AE and economic activity

This lowers the prices of other assets such as property.

↓wealth households → ↓C → ↓AE and economic activity

Advantages/Disadvantages

Like all economic policies, monetary policy has its strengths and weaknesses. During the recovery, the strengths of it are that it is flexible, is independent from political policies and is most effective under a floating exchange rate. However, it also has weaknesses, including time lags, being less effective in a recovery, and being a blunt instrument.

 Flexible

This is arguably the greatest strength of monetary policy. Decisions about appropriate domestic operations are made every day by RBA – more flexible than fiscal (once a year). It also doesn’t need specific permission from parliament, so decisions can be made and implemented very quickly, making it a strength of monetary policy during a recovery as the RBA can change its cash rate every month (except Jan) according to changing economic conditions.

Greater political neutrality

Transmission route for monetary policy is more subtle than that of other policies. Interest rates affect every sector of the economy so people are less likely to see the policy as being aimed at them. Decisions made by RBA are based solely on economic reasons, with no political influence, meaning that the decisions it makes are intended to help the economy through its recovery, even if it means doing things that aren’t viewed favourably by the public such as raising interest rates.

↑ Effectiveness under floating exchange rate

Changes in IR affect the IR differential between Aus and other countries. In a recovery, the RBA will initially cut IR to encourage spending, causing a fall in capital inflow. This reduces the demand for our currency causing depreciation in the AUD. This has a positive effect on the domestic economy as export prices fall and become more competitive internationally while import prices rise, making them less attractive to Aus buyers. This increases net exports (X-M), increasing AE in economy.

Time lags

Two types: inside lag and outside lag

Inside lag is the time taken to undertake a policy action. It includes the recognition lag (time to recognise change in economic conditions), decision lag (time taken to make a policy decision) and action lag (time taken to implement policy decision. This lag however, is relatively short compared to fiscal policy as MP can be implemented quickly and easily.

Outside lag is the time it takes for the policy to actually affect the level of economic activity, also called “the effect lag”. This lag for MP is longer than for FP because Mp works indirectly through IR to affect level of AD, whereas FP works more directly through changes to gov. spending or tax which affect AS quicker.

These lags are bad for the economy because they slow down the recovery of the economy.

Less effective during recovery

MP is more effective in a boom than in a recovery. This is because low IR may not be enough to stimulate spending as they have low levels of confidence in the economy in and do not expect favourable conditions in the future during the early recovery. Eg. Japan – 0 % IR – still not v effective. This situation is called a liquidity trap where low IR don’t help to stimulate C or I. Fiscal policy is needed to help the economy through the early recovery as it has a more direct impact on C and I decisions.

It is more effective at the end of a recovery as IR are better at controlling high levels of AD and inflation apparent in late recovery. This is because higher IR has a more direct effect on economic conditions than lower rates. Therefore, when IR high, they assume a very important role in the decision making process of borrowing households or investors calculating their MEC.

Blunt Policy

Effects everyone – changes in IR same for everyone – can’t just ↑WA and same for rest of Aus. Falls unevenly of sectors of economy – eg. Heaviest on housing and cars.

Ineffective dealing with cosh push inflation

MP doesn’t cure cost push inflation, only demand pull inflation because it is a demand side policy. This means if there are supply shocks such as labour shortages during the late stages of a recovery, changes in IR by RBA will have little impact in helping solve the problem.

Crop circles are usually found in trees, ice and of course crops. The ones that were found around the 1970’s were fairly simple. Some people have made it a hobby to go out at night and make crop circles these people are usualy found in England.

When crop circles are made ( not made by humans) witnesses claim they heard a high frequency sound. When crop circles arn;t human made there stems are charred and the node is bent and expanded.

After World War II the sightings and complexity increased. This may be because of the more planes flying over-head. They are usually found around Southern England where there is a large amount of crop fields.

It is simple to tell if crop circles are human made or not. If they are the stems are broken…If there not the stems are bent. Are these made by extra terrestrials or a natural cause?