FINA 2002: Impact of RBA Cash Rate Decisions on Economic Activity

This report critically examines the influence of official cash rates on economic activity in Australia, referencing FINA 2002. It explains how changes in cash rates, determined by the RBA, affect interest rates, consumer spending, and GDP growth. The analysis covers the RBA's decision to keep the cash rate constant in October 2018 and to slash it in December 2012, relating these decisions to market responses, global economic conditions, and domestic economic indicators. The report supports its arguments with examples from market reactions and references to relevant economic principles and RBA statements, concluding that cash rate adjustments play a crucial role in shaping economic outcomes with a typical lag effect.

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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

would increase which would lead to a boost to the economic growth and GDP. Driven by
higher consumer demand and cheaper availability of credit, the private investment would also
boom and provide further impetus to economic growth. It is evident from the above
discussion that cash rate tend to play a critical role in influencing the economic activity in the
country. However, there is a typical lag effect with regards to the above changes being
witnessed in the economy (Krugman & Wells, 2014).
b) With regards to the decision taken by The RBA to keep cash rate constant in October
2018, it is apparent that the economists along with the financial markets were expecting the
same. This is apparent from the fact that the financial markets did not respond with any major
changes on either sides and essentially the policy became a non-event (Scutt, 2018).
Considering the state of national and global economy as highlighted by RBA, the decision
seems to be indeed prudent. This is because the Australian economy is recovery and forward
estimates tend to highlight that improvements in the future macroeconomic data might be
expected. Thus, there was no need to reduce the interest as it would have resulted in an
unnecessary stimulus especially when the cash rate is being maintained at the record low.
Also, there was no strong case for any hike in cash rate as it would have stalled the current
economic growth witnessed in Australia. Besides, there are ongoing risks to global economic
growth owing to the trade tariffs being put by USA. The consumer spending trends in
Australia continue to remain unclear which requires ongoing support in the form of low
interest rate (RBA, 2018). As a result, it made sense on the part of the RBA to continue with
the neutral policy stance whereby in the near future the cash rate is expected to remain at a
constant level.
With regards to the decision taken by The RBA to slash the cash rate by 25 bps in December
2012, it is apparent that the financial markets were expecting the same since this
announcement was not met with any significant movement in the benchmark index (Kwek,
2012). The underlying reasons tendered by the RBA through the minutes were quite
compelling especially considering the concern around global growth particularly around
crisis in Europe which was adversely impacting global growth at that time (Kindley, 2012).
Additionally at the time, the cues from domestic economy were also not encouraging and it
was expected that the future growth projections along with macroeconomic data would
further worsen (RBA, 2012). In such a backdrop, lowering the cash rate if passed on by the

banks in the form of lower interest would enhance the demand of loans coupled with
lowering instalments. The net result would be higher consumer spending which would
provide an impetus to private investment and hence provide the much needed support to
Australian economy at the time when the mining sector was underperforming (Mankiw,
2014).

References
Kindley, B. 2012. RBA Rates Decision – December 2012, Accessed 25 Nov. 2018 from
https://empowerwealth.com.au/blog/rba-rates-decision-december-2012/
Krugman, P. & Wells, R. 2014. Macroeconomics. 3rd ed. London: Worth Publishers.
Kwek, G. 2012. RBA lowers rates to GFC levels, Accessed 25 Nov. 2018from
https://www.watoday.com.au/business/home-loan-guide-20090303-8mxh.html?
_ga=2.170875296.1638602129.1543152189-1393941143.1540963189
Mankiw, G. 2014. Principles of Macroeconomics. 6th ed. London: Cengage Learning.
McConnell, C., Brue, S. & Flynn, S. 2014. Macroeconomics: Principles, Problems, &
Policies. 20th ed. New York: McGraw Hill Publications.
RBA. 2012. Statement by Glenn Stevens, Governor: Monetary Policy Decision, Reserve
Bank of Australia, Accessed 1 Nov. 2018, from: https://www.rba.gov.au/media-
releases/2012/mr-12-36.html
RBA. 2018. Statement by Philip Lowe, Governor: Monetary Policy Decision, Reserve Bank
of Australia, Accessed 1 Nov. 2018, from:
https://www.rba.gov.au/media-releases/2018/mr-18-24.html
Scutt, D. 2018. The RBA's latest interest rate meeting must have been quick, Accessed 25
Nov., 2018 from https://www.businessinsider.com.au/here-comes-the-rba-interest-
rate-decision-2018-10