Loanable Funds Market in Australia free essay sample

1. Introduction: The Reserve Bank of Australia is considering an increase in the target cash rate by 25 basis points in the near future. It is the intention of this report to analyse the positive and negative impacts of a rise in interest rates on the loanable fund market in Australia. In order to analyse the impacts of an increase in interest rates on the loanable fund market, the reasons behind the possible rate rise in the near future will be looked upon. Charts and diagrams have been used to illustrate the intention of this report and it is hoped that by looking at these vital elements the intended user will be able to understand the issue more thoroughly and follow the analysis behind it and get a clear understanding of the issue. 2. Cash Rates of the Reserve Bank of Australia(RBA): The Reserve Bank’s monetary policy actions are directed towards influencing the level of interest rates in the financial system on order to achieve its economic objectives (Viney, 2005). Cash rates are the interest rate paid in the interbank market for exchange settlement account funds. The target cash rate can only be set by the Reserve bank, it is decided monthly when the board of the Reserve Bank (RBA) meets and considers various financial indicators from around the world and target inflation rate. The main purpose of the cash rate is to control inflation. Kruger Coorey (2007), state that The Reserve Bank has announced a 0. 25 percentage point increase in interest rates this morning to 6. 5 per cent. This increase has an influence on output, employment and prices through a number of complex, related channels which affect the cost and availability of funds to the business and household sectors. Source: Sydney Morning Herald, 2007. When there has been a change in the trend or level of cash rate, then the bill rates and commercial loan rates will adjust followed by mortgage and retail lending rates (Viney, 2005, p. 424). When the Reserve Bank of Australia wants to lower the cash rate, it supplies more cash than the banks like to hold, as a result they will lend more money to money market resulting in a fall in the cash rate. And if they want to raise the cash rate they do the exact opposite. The main objective of the RBA is to control the cash rate, as by doing this they control inflation, which is vital for the economy’s wellbeing. 3. The loanable funds market in Australia: According to Viney (2005), Loanable funds are the amount of funds available within the financial system for lending. 3. 1 The Loanable funds Model: In the loanable funds approach it is assumed that there is downward sloping demand curve for funds and an upward sloping supply curve for interest rates. The demand curve represents the demand for credit by borrowers and the supply curve represents the supply of credit by lenders (Evans,1999). Borrowers (represented by the demand curve) include consumer borrowers (credit cards, home loans, etc. ), businesses of all kinds (corporate borrowing, trade credit, etc) (Evans, 1999). Source: Evans(1999) Lenders (represented by the supply curve in the loanable funds model) include direct lenders, such as banks, mortgage companies, credit card companies (Evans, 1999). The supply of loanable funds comes from those who spend less than they earn, while the demand for loans comes from households, companies and governments who wish to borrow funds to make investments (Miller, 2004). The downward slope of the yield curve implies that the demand for funds will increase as interest rates rises and the upward sloping supply curve shows that an increase in the supply of loanable funds will allow interest rates to fall (Viney, 2005, p. 447). The interest rate(r) is determined by the equilibrium between demand and supply. Changes in the position of the demand and supply curves will result in changes in the rate of interest. Source: Viney,2005 At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied. If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded would be smaller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down. Similarly, if the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded would be greater than the quantity of funds supplied. The shortage of loanable funds would result in upward pressure on the interest rate (Mankiw, 2001). 4. Effect of demand on Interest rates for Loanable Funds: The demand on interest rates for loanable funds affects the Household sectors, Business sectors and Government sectors. 4. 1 Household Sectors: The impact of a rate rise decreases the demand for the loanable funds from the household sector. As this foreseeable increase interest rate could add $50 to the monthly repayments on a $300,000 mortgage. This may discourage many new home buyers to differ from buying a house for now, due to the added costs of taking out a mortgage during a period in which interest rates are expected to be high. However, at present in Australia the demand for housing is positive and high. The household sector is doing very well, despite the Reserve Bank raising interest rates, said Westpac senior economist Andrew Hanlan (Bourlioufas Wires, 2007). This is so because the low petrol prices helped the household sector in doing well (Bourlioufas Wires, 2007). However, inspite of the household sector doing well Banks are likely to remove discounts for new customers first, while poorer credit risks will find it impossible to get home loans at all (Uren, 2007). If the interest rates keep rising then according to Mr Braddick, housing affordability will gradually deteriorate further in the year ahead and this would be a negative impact on the loanable funds market in Australia. Kruger Coorey, 2007). Therefore, consumers have to be careful n sure about taking a home loan at the moment as they might end up paying higher interest rates. 4. 2 Business Sector: A rise in the interest rates will effect the demand for loanable funds in the business sector. The higher the rate of interest, the lower would be the volume of funds demanded and the lower the rate of interest, the greater will be the volume of funds demanded. This is represented b y a downward sloping curve (Viney, 2007). According to Campbell(2007), the small business sector which employs about a million people and will bear the increased cost in regard to their mortgages and those people will bear the increased cost in regard to their borrowings as small businesses. Rise in interest rates is a blow to all hardworking small business people. Half the borrowings of small business people are at variable interest rates, and those people will be hit hard by a rise in interest rates. Businesses with borrowings of $200,000 will pay an additional $500 per year.