“c04AggregateDemandPoliciesAndDomesticEconomicStability_PrintPDF” — 2022/6/7 — 8:31 — page 340 — #54
FIGURE 4.18 How interest rates are determined in the cash or short-term money market Price of cash (%) S1 (supply of cash in the STMM is determined by the RBA)
The RBA’s cash rate target (CRT)
PR O
O
FS
Market equilibrium
D1 (demand for cash in the STMM by banks) Q1
E
Quantity of cash traded
CO RR EC
TE
D
PA
G
Referring to this diagram of the STMM, notice the following: • The demand for cash (D1 ) is determined by the needs of Australia’s commercial banks (i.e. the NAB, CBA, Westpac and ANZ) when they must make cash transfers or payments into the ESAs of other banks at the end of each day. Like normal demand lines, this has a negative slope. • In contrast, the supply of cash (S1 ) is directly controlled by the RBA. It is shown here as a vertical line since the RBA has a monopoly in the supply of cash. • Finally, there is the market equilibrium price or cash rate of interest for borrowing and lending in the STMM. It occurs at a point where the quantity of cash demanded and supplied are exactly equal. As its main instrument of monetary policy, the RBA Board sets and pursues a cash rate target or the ideal level for short-term interest rates that it believes will help to improve Australia’s domestic macro conditions and living standards.
4.11.2 The cash rate target and the policy interest rate corridor
N
We have now seen that in the STMM, banks are legally required to maintain positive cash balances in their ESAs at the end of each day’s trading. For this clearing or settlement process to happen overnight, each bank must maintain a positive balance in their ESA. This requires banks to borrow and lend cash in the STMM at a level called the cash rate. As the key instrument of monetary policy, the RBA sets a desirable cash rate target for this market, that it changes from time to time in response to new economic conditions. In turn, competitive forces and consequent ripple effects cause any change in the short-term cash rate to indirectly affect other longer-term interest rates, AD, and the level of economic activity.
U
However, there is a bit more to understanding the STMM and how the RBA seeks to push the cash rate to a level close to the RBA Board’s announced target cash rate. This level is possible because within the STMM, the RBA operates what is called the policy interest rate corridor or band of interest rates within which borrowing and lending by all banks and some other financial institutions must occur. It is a guidance system and involves the RBA setting a ceiling rate and a floor rate of interest in the STMM that sit above and below the RBA’s desired cash rate target. This is shown in figure 4.19.
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Key Concepts VCE Economics 2 Units 3 & 4 Eleventh Edition
