The RBA and the cash rate

Question 1

What is the cash rate?

Answer 1

The interest rate in a fundamental financial market called the overnight money market - the market for very short term loans between banks.

Question 2

Why are the three components of the mechanics of the cash rate?

Answer 2

Exchange settlement accounts
The policy interest rate corridor
Open market conditions

Question 3

Where do banks need to keep a proportion of their funds with the RBA?

Answer 3

In exchange settlement (ES) accounts

Question 4

Why do banks need to keep a proportion of their funds in ES accounts with the RBA?

Answer 4

In order to ensure that they settle payments with other banks and the RBA.

Question 5

How are transactions between banks facilitated?

Answer 5

Through the funds in ES accounts.

Question 6

What happens at the end of every trading day with banks and their funds in ES accounts?

Answer 6

Some banks will not have enough funds in their ES accounts to satisfy all their interbank payments for that day. Others may have an excess of funds in their ES accounts, or deliberately put extra funds in to store value.

Question 7

What is the overnight money market/ short-term money market?

Answer 7

A financial market where banks with a shortage of ES funds can borrow from banks with a surplus of ES funds.

Question 8

What does the short-term money market enable?

Answer 8

It enables banks to always settle their interbank payment obligations.

Question 9

What occurs when supply of funds from lenders with excess ES funds increases?

Answer 9

The price of borrowing this money, the cash rate, falls.

Question 10

How is the supply of funds determined in the short-term money market?

Answer 10

The RBA intervenes heavily to ensure that the actual cash rate meets their target. Does this by using policy rate corridors and open market operations. This makes the supply of the cash market perfectly inelastic.

Question 11

What rate of interest does the RBA pay to banks on funds held in ES accounts?

Answer 11

The RBA pays an interest to banks that 0.25 points below the cash rate target.

Question 12

What is the effect of the RBA paying 0.25 points lower than target on the bank deposit rate?

Answer 12

This means that banks with ES balances are not incentivised to lend to other banks , because they could earn greater returns by leaving funds in the account. This creates a minimum value for the cash rate.

Question 13

Why does the RBA set an interest on ES account loans 0.25 point below the cash rate target?

Answer 13

To discourage banks that need to borrow Es balances from paying a rate higher than the RBA’s lending rate. This creates a maximum value for the cash rate.

Question 14

What is the policy rate corridor?

Answer 14

The combination of the RBA’s lending and deposit rate, that create a ‘corridor’ centred on the cash rate target. It ensures no banks, that have surplus or deficit funds, have an incentive to complete transactions in the overnight money market at rates far away from the cash rate target.

Question 15

How does the RBA influence the actual cash rate within its corridor?

Answer 15

The actual cash rate is the intersection of demand and supply of ES funds. The RBA directly manages the supply of ES funds to meet demand at their desired cash rate.

Question 16

How does the RBA manage the supply of ES funds to maintain its desired cash rate?

Answer 16

It conducts domestic market operations, which are the transaction of financial securities (Commonwealth gov. securities) in exchange for ES balances.

Question 17

What occurs if the demand for ES funds increases? (Explain what the RBA will do in terms of DMO)

Answer 17

If demand for ES funds increases, the RBA would need to increase supply to maintain its cash rate. So, it would buy financial securities from banks and deposit ES balances into their accounts, increasing supply.

Question 18

How would the RBA respond to a decrease in demand for ES funds?

Answer 18

To maintain its cash rate, it would sell sell financial securities and withdraw funds from ES accounts - decreasing supply.

Question 19

What is the most common form of DMO that the RBA carries out?

Answer 19

The RBA buys or sells repurchase agreements (repos) where the ‘seller’ of the bond agrees to buy the bond back from the buyer at a later date. They are used most frequently because they are flexible.

Question 20

What is the effect of an increase in the cash rate?

Answer 20

It becomes more expensive for banks to obtain funds in the short term money market. This increases the overall cost of borrowing, eventually flowing to mortgages and other interest rates as banks try to maintain their profit.

Question 21

What is the effect of an increase in the cash rate?

Answer 21

This lowers the cost of borrowing for banks in short term money market, and banks pass on this cost saving to their customers through lower lending rates.

Question 22

How do interest rates impact economic activity?

Answer 22

Decreased interest rates encourage spending and investment, increases economic activity? and vice versa.

Question 23

What generates the demand for funds in the short-term money market?

Answer 23

Funds needed by banks to keep their ES accounts in surplus.

Question 24

In what situation will demand for funds in the STMM increase?

Answer 24

If banks expect higher outflows and need to access more funds.

Question 25

In what situation will demand for funds in the STMM decrease?

Answer 25

If banks expect lower outflows.