Why does the rba lower interest rates

This website is best viewed with JavaScript enabled, interactive content that requires JavaScript will not be available. The Reserve Bank of Australia implements monetary policy by undertaking transactions in domestic money markets.

These transactions are mainly conducted in an auction following a public announcement to all commercial banks that the central bank intends to buy or sell cash. The price a commercial bank is willing to pay determines who is, and who is not, successful in obtaining cash.

How monetary policy is implemented can be explained by stepping through five aspects of the cash market: the price, quantity, demand, supply and the policy interest rate corridor.

The cash market is where banks lend and borrow funds from each other overnight. The price in this market is the interest rate on these loans. In Australia, this interest rate is called the cash rate. The quantity traded in this market is called Exchange Settlement ES balances, which are used to settle interbank transactions.

Banks have deposit accounts at the Reserve Bank to record the value of their ES balances. Because the Reserve Bank is Australia's central bank and controls banknotes available to the public, ES balances are considered to be the equivalent of cash.

Banks use ES balances as a store of value and to make payments between each other. Some of these payments are on behalf of their customers and some are related to their own business. The Reserve Bank estimates the demand for ES balances each day. Demand may vary for a number of reasons, including changing financial market conditions. The Reserve Bank manages the supply of ES balances. Supply is set so that it meets demand and the cash rate is as close as possible to its target.

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Lawson and Rees find that housing investment and business investment in machinery and equipment are actually the most sensitive components of GDP expenditure to changes in monetary policy.

But this research does not provide specific evidence for any particular channel of monetary transmission. Lower interest rates influence the spending decisions of households and businesses by reducing the amount of interest they pay on debt and the interest they receive on deposits.

This is commonly referred to as the cash flow channel of monetary policy. Recent research points to evidence of the cash flow channel for both borrowing and lending households La Cava, Hughson and Kaplan However, the cash flow channel is stronger for borrowers for two reasons. First, the Australian household sector as a whole is a net debtor.

The average borrower holds two to three times as much variable-rate debt as the average lender holds in interest-earning assets Graph 3. As a result, lower interest rates lead to higher cash flow in the aggregate economy. Second, the spending of borrowers is more sensitive to changes in cash flow than the spending of lenders.

This is because borrowers are more likely than lenders to be constrained by the amount of cash they have available. Taking the effects on borrowers and lenders together, one set of estimates suggests that lowering the cash rate by basis points increases total household disposable income by around 0. This channel recognises that asset prices and wealth are key determinants of household and business spending. Fluctuations in asset prices not only affect households' and businesses' overall wealth the wealth channel , but also their borrowing capacity the balance sheet channel.

A key difference between the wealth channel and balance sheet channel is that changes in wealth potentially affect all households and businesses, while changes in borrowing capacity mainly affect the spending of those that are currently constrained by how much they can borrow.

However, this does not imply that the balance sheet channel is weaker than the wealth channel; the spending of constrained borrowers is typically very sensitive to changes in asset prices. A range of Australian studies have looked at this channel for household spending.

There is general consensus that lower interest rates lead to higher asset prices, and that higher wealth is associated with more household spending.

This result is more consistent with the balance sheet channel than the wealth channel, and highlights how difficult it can be to disentangle the channels in practice.

There is also extensive evidence from overseas that businesses balance sheets matter for the transmission of monetary policy, and there is some Australian evidence too. For example, Jacobs and Rayner show that an unexpected decrease in the cash rate results in fewer businesses reporting difficulties obtaining bank funding.

La Cava finds that cash flow matters to business investment decisions, suggesting that monetary policy can also affect business investment through this channel.

Interest rates influence the exchange rate, which can have a notable effect on economic activity and inflation in a small open economy such as Australia.

Typically this channel is stronger for sectors that are export-oriented or exposed to competition from imported goods and services. The exchange rate also has a direct effect on inflation. One set of empirical estimates for Australia suggests that the effect of interest rates on the exchange rate is relatively small.

There is also evidence that changes in the exchange rate affect exports and imports. Estimates suggest that a 10 per cent depreciation lifts export volumes by 3 per cent while reducing import volumes by 4 per cent within two years. The resulting increase in net exports leads to higher economic activity.

With regard to the direct effect of the exchange rate on inflation, estimates suggest that a depreciation of the exchange rate leads to a large and immediate increase in import prices. However, the subsequent effect of higher import prices on the final prices that households pay is smaller and occurs more slowly.

The implementation of monetary policy and how the Reserve Bank maintains the cash rate at its target level is discussed in Baker and Jacobs These estimates come from a macroeconomic model based on Rees, Smith and Hall Brischetto and Voss , Dungey and Pagan and Berkelmans also find that unexpected changes to the cash rate affect output and inflation.

The perspectives on the transmission of monetary policy in this article are similar to those internationally. For more discussion of the transmission of monetary policy, see Mishkin and George et al The neutral rate can be thought of as the rate required to bring about full employment and stable inflation over the medium term.

When the cash rate is below the neutral rate, then monetary policy is exerting an expansionary influence on the economy, and if the cash rate is above the neutral rate, then monetary policy is exerting a contractionary influence on the economy. While the focus is often on the change in the cash rate, it is also important to understand how far the cash rate is from the neutral rate.