Will lower interest rates work?

The Australian central bank, the Reserve Bank of Australia (RBA), reduced interest rates to a record low of 1.75% last week. The financial markets are sure this is not the last cut in interest rates with some forecasting a rate of 1%, but everyone is sure 1.5% will be seen soon.

The cash rate is Australia's 'bank rate' the lowest rate at which commercial banks can obtain cash if they need it. The RBA is cutting their cash rate because inflation is below their 2 - 3% target and without the cut would be well below that. Economic theory tells us there are a number of ways a fall in interest rates help boost Aggregate Demand (AD), the transmission mechanism of monetary policy. Theory also tells us that it takes 18 months to two years to have its full effect.

The question many are asking is 'will it work'? One mechanism by which cutting interest rates work is by discouraging savings and so booting consumption. However interest rates are already so low why would cutting savings rates discourage more saving? Households save for precautionary reasons as well as financial gain and it might be that most current savings fall into that category.

Another reason lower interest rates boost AD is that it is cheaper to borrow, encouraging both firms and households to invest and consume more. But is business and household confidence high enough for them to act on a small rate cut to a very low rate?

Low interest rates will also harm some members of society. Savers. The biggest groups of savers are retirees and those saving for superannuation fund. Retirees will find their income from saving will fall, and indeed the real value of those savings might fall as inflation exceeds interest rates paid. This will discourage consumption by retired households. Those who are saving for retirement might actually save more as they see the need for a bigger 'pension pot' for their future security. Therefore the interest rate cuts may act to reduce current AD.

The article below provides a survey of the situation and has some good short videos embedded. What is clear is that when interest rates are low cutting them further is like "pushing on a piece of string". While one end moves, the other end stays where it is. Lowering interest rates may have no effect on inflation or AD.

The Age article is here

VCE students need to know the transmissions mechanisms of monetary policy the study design identifies by name. Two or three mechanisms usually suffice. They should also know why monetary policy has been implemented as it has been since 2013. IB students need to understand the operation of monetary policy and be prepared to analysis and evaluate its effectiveness under different circumstances.