Role of Cash Rate in Influencing Economic Growth in Australia

FINANCE
STUDENT ID:
[Pick the date]

Question 1
a) Cash rate may be defined as the interest rate which the banks change for providing
overnight loans. Considering that these interest rates are applicable for the lowest term, hence
this tends to serve as the benchmark rate over which premium is applied based on the loan
duration and creditworthiness of the borrower in order to determine the applicable interest
rate. It is evident from the above description that cash rate plays a crucial role in determining
interest rates for the lenders. The cash rate is determined by RBA (Reserve Bank of
Australia) and revised in order to ensure that the inflation remains within the targeted range
(Krugman & Wells, 2014).
Changes in the cash rate can bring about significant changes in the economic growth of
Australia. Consider for instance a hypothetical situation where the cash rate is hiked by 50
basis points (bps). As a result, the borrowing cost for overnight funds would become
expensive for the commercial banks in Australia and hence the banks would tend to revise the
interest rates higher. Owing to the higher interest rates, the interest payments for the existing
borrowers would increase leading to higher outflow in meeting the equal monthly
instalments. As a result, the disposable income available with these people for spending
would tend to reduce. Additionally, the customers that would have been interested in taking
loan would be discouraged to some extent, thereby reducing the demand for loan. Owing to
lower disposable income for existing borrowers and lesser demand for new loans, there
would be lower consumer spending which in turn would have an adverse impact of GDP
(Mankiw, 2014). This effect may spill over to investment by private sector which may also
get postponed owing to higher interest costs and lower consumer demand which again leads
to lower GDP growth. Also, disposable income may also be adversely impacted since the
interest rate on deposit may increase which would provide higher incentive for people to save
and hence cut down on spending (McConnell, Brue & Flynn, 2014). Thus, it is evident from
the above discussion that an increase in the cash rate would lead to a slowdown in the
economy.
Similarly, a lowering of cash rate would tend to lead to lowering of interest rates by the
banks. This would increase the demand for new loans and also lower the EMI payment for
the current loan holders. Also, the deposit rates may be cut which may provide greater
incentive for the people to spend more rather than to save owing to poor interest rates on
bank savings. The net impact of the above changes would be that the consumer spending