Definition of Interest RateAn interest rate is the percentage yield on a financial security or asset such as a loan, bond or savings deposit. A variety of interest rates exist in the economy because of differences in the risk, liquidity and maturity of various financial instruments or assets.Different Types Interest Rates (% per annum)Bank Current Deposit (at call) - 0.00%, June 2005Cash Rate Target - 5.50% (+0.25%), 2nd March 2005Banks Fixed Deposit Rate $5000 to $100,000 (5 years) - 4.75%, June 2005Finance Company Debentures (3 years) - 5.40%, June 2005Large Business Overdraft Rate (3 year variable) - 9.10%, June 2005Small Business Overdraft Rate (3 year variable) - 9.60%, June 2005 ...view middle of the document...
Time and maturity of a financial asset impacts on the interest rate. Short to medium term financial securities tend to have lower interest rates than longer term securities. The relation between short, medium and long term interest rates in known as the term structure of interest rates.The Role of the Reserve Bank of Australia in Interest Rate DeterminationThe Reserve Bank of Australia's (RBA) main responsibility is formulating and implementing Monetary Policy; which is a macroeconomic policy instrument used for counter cyclical stabilisations. Policy decisions are made by the Reserve Bank Board with the following objectives:Objective Target InstrumentPrice Stability 2% to 3% CPI inflation Cash Rate and DMO'sFull Employment NAIRU of 5% to 6% Cash RateEconomic Growth Sustainable Growth of 3% to 4% Cash RateThe RBA implements monetary policy through its market operations. Market operations refer to the buying and selling of Commonwealth Government Securities (CGS) and Repurchase Agreements (Repos) by the Reserve Bank in the cash market. The RBA sets a cash rate target each day in the cash market and attempts to ensure sufficient liquidity or cash to meet market demand so the cash rate doesn't change (this is known as liquidity management).The cash market is a market for financial institutions to have access to deposit and lending facilities to settle debts between themselves, via their Exchange Settlement Accounts. Banks, financial institutions and large companies deposit any surplus cash in the market in order to earn interest. Conversely, institutions with a deficit in cash can borrow from the cash market. The demand for cash is determined by the reserves of cash (Exchange Settlement Funds) held by banks in their ESA's with the RBA.The RBA controls the volume of cash through its direct market operations (DMO's) on a daily basis. Purchases of CGS and Repos by the RBA will lead to a rise in the supply of cash in the banks' ESA's/ When the RBA sells CGS or Repos commercial banks will withdraw funds from their ESA's and make a payment to the RBA, reducing the supply of cash in the market.Sale of CGS or ReposPayments of CashEffects of monetary lightening1. A decrease in the supply of cash or liquidity in the cash market2. A higher cash rate and other maker interest rates that make up the yield curveThe above figure illustrates how the RBA can tighten the stance on monetary policy by changing the cash rate using market DMO's. If the RBA wants to tighten monetary policy it would sell CGS and Repos, withdrawing cash from banks ESA's. This would decrease the supply of cash and liquidity in the cash market relative to the demand for cash. The cash rate would rise and eventually flow on to other market interest rates leading to higher interest rate structure in the economy. This would discourage spending and reduce inflation and inflationary expectations. However, if the RBA saw the need to ease monetary policy it would buy CGS or Repos from commerc...
