Economics Q&A

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Recommended:  the impact of Monetary and fiscal policy

Q1) What is the difference between the official cash rate and the market rate of interest? Explain the mechanism by which the RBA raises the cash rate. Use appropriate diagrams where necessary.

The official cash rate is the interest rate set by the central bank for the financial institutions. This rate is adjusted by the central bank via the Exchange Settlement Accounts. The official cash rate is influenced by the transactions taking between the central bank and the financial institutions because such transactions change the money supply. If the financial institutions are trading within themselves, then the official cash rate will not change since the money supply is constant. On the other hand, the market interest rate is one which is influenced by the financial institutions and one which is referred to when financial institutions trade within themselves. This rate is usually greater than the official cash rate since it contains an element of risk.

The government can alter the cash rate through open market operations that is buying or selling the government securities. The cash rate is an indicator of the cash available in the economy. When the government intends to increase the cash rate, it sells the government securities to banks and financial institutions. In such a situation, the banks and other financial institutions buy the securities and this result in a decrease in the money supply. When the money supply decreases, the market forces cause the interest rate to rise since the funds are comparatively lesser in the economy (Global-Rates.com). This concept is shown in the graph where it can be seen that when the money supply decreases, the interest rates will go up given that the demand for money does not change. Therefore ...

... middle of paper ...

...ing the reserve requirement ratio and curbing the investments and aggregate demand. (Australia)

Works Cited

Australia Reserve Bank of Measures of Consumer Price Inflation [Online] // Reserve Bank of Australia. - http://www.rba.gov.au/inflation/measures-cpi.html.

College Harper Monetary Policy [Online] // Harper College. - http://www.harpercollege.edu/mhealy/eco212/lectures/moneypol/mp.htm.

Finpipe Monetary Policy [Online] // Finpipe. - http://www.finpipe.com/monpol.htm.

Fuentes Gilberto The Effect of Interest Rates on Inflation & Unemployment [Online] // eHow. - http://www.ehow.com/info_7745833_effect-interest-rates-inflation-unemployment.html.

Global-Rates.com RBA Official Cash Rate, Australian central bank’s interest rate [Online] // Global-Rates.com. - http://www.global-rates.com/interest-rates/central-banks/central-bank-australia/rba-interest-rate.aspx.

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