Interest rates

From: Adam Randall

Can someone explain to me what makes interest rates rise and fall, I was under the impression that when times are good and there is alot of spending interest rates are set higher to stop the flow of money getting out of control, conversely when times look bad interest rates are dropped to encourage higher spending.

If this is the case how is an extract from a recent post to be explained ,

"Did anybody watch "Today Tonight" last night on Channel 7, Melbourne. Heading was "Property Boom, Bust". The report said that even before September 11 and the global economy slowdown, property in Sydney, Melbourne and to a lesser extent Brisbane is predicted to fall by 5 to 10% over the next 6-12 months, due to it being majorly overpriced. I'd hate to imagine what it will drop to when there is a major economic slowdown, more people lose their jobs and interest rates start to rise. BIS and Shrapnel(I think that's who they are) predicted interest rates to be at 9.5% in 2004, adding $150 per week to a $200k home loan. Time to lock in. Scary. Any thoughts on this and has anybody seen similar reports"

my thoughts would have been that if times get worse the RBA will drop rates even further, it annoys me that I think I am just starting to understand how things work, then I read something that makes me realise I do not really have a clue.
Also another question interest rates have dropped, inflation has gone up, what happens when inflation is higher than the interest rate the banks charge (can this even happen).
Regards Adam
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Reply: 1
From: Sim' Hampel

I think we need some economics experts to help out here... but my understanding is that there are two major factors that affect interest rates and that the govt uses interest rates to control (circular feedback system).

There is a measure called inflation, based on how much things cost (cars, houses, milk etc.)

There is a second measure called growth, based on how the "economy" is growing... ie. how much more money is running around the system or something like that.

I think we are in a situation where inflation is up (due to "a depreciating currency and an expansionary fiscal setting")but growth is slowing... which means that we are in one of those volitile situations where we risk having inflationary blow-out by setting interest rates too low while trying to kick start economic growth.

Basically, it seems that when the economy starts growing again, they will need to apply the brakes pretty smartly to keep inflation under control, meaning that rates could get higher quite quickly.

In other words... don't count on interest rates staying low for a while.

And also don't count on me making any sense about all this... I'm struggling to understand the economics of it all myself !

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Reply: 1.1
From: Nigel W

Ditto Sim's comments.

As i understand it, the Reserve bank's charter is twofold: to help maintain the strength of the currency and to keep inflation within the RBA's target range of 2-3%.

Interest rate adjustments by the RBA are largely directed to this second objective. RBS currency dealing (ie restricting or increasing the supply of $A impacts largely on the former) - although both acts impact the other.

remember interest rates are just the price of money and the price of any item is inversely related to supply ie high supply low price and directly related to the demand ie high demand equals high price.

...of course even if you understand the theory, in practice the economy and the real estate and share markets are functions of HUMAN supply and demand. And we all know that often humans behave irrationally! So the theory will not always reflect the reality.

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Reply: 1.1.1
From: Tom Cleary

Hi Adam
If you want a reasonably coherent explanation about what is happening in the world of economics, you could do worse than have a look at Roger Garrisons powerpoint presentation at
(right hand side).
However it can open up a can of worms,s as it is very critical of what passes as main stream economics amongst policy makers today.
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Reply: 2
From: Michael G


This is my understanding, but its been gathering by various readings but nothing has been confirmed (so if anyone out there has an official document, I'd love to see it).

As far as I know, governments don't control interest rates, each country's central bank does. Why?, well if it was left to those in government, our economy would be screwed up by those trying to win political favors.

Ok, so if the central banks adjust it, the question is how and why.

Well first one needs to think about the buying power of money. But before that let me just talk about fractional banking as I understand it.

A long time ago, a country's money supply was fixed against a gold standard. That is, if a country had $1 million in gold they could print $1 million in notes. The more gold, the more notes. In fact one could exchange their cash for gold and visa-versa.

Then sometime after that, someone thought this limited the economy and worked out a system called fractional banking.

Basically, instead of having gold deposits. All a bank required was a cash deposit kept in reserve. For example for every $5 of deposits, a bank could lend out $100 in loans.

So what the Reserve bank does is dictate;

1) How much reserve a bank must keep in reserve

2) What the interest rates will be.

So how do these two things control the economy?

Well the smaller the reserve required to be held the higher the ratio to loans to cash there is in the economy.

If banks need less reserves they are able to lend more based on smaller deposits. This makes the amount of available funds to the economy greater. The more funds (ie supply of cash) the cheaper the money costs to borrow.

And when the reserve bank drops rates, the cheaper the cost of money is, and so the more people borrow.

The more money in circulation the more stimulated the economy is. People borrow more and buy more.

But the downside is. The buying power of the dollar drops. Why?

Well the value of an item never changes. 1kg of gold, will always be 1kg of gold.

For example, lets say we had an economy where there existed only 1000 kg of gold and at the time there was only $1 million in circulation. Then in this simple example each 1kg of gold would be worth $1000.

But lets imagine the central bank allows $2 million to circulate into the economy. Now there is twice as much money available, but remember there is only exists 1000kg of gold.

So now 1kg of gold costs $2000 simply because the supply of goods remain the same.

That is a very simplistic way of looking at inflation.

You see, a house is made of bricks, glass and wood and labour. The 'value' of this has never changed really, its the buying power of the dollar which has. That and the supply of land and peoples desires.

So what happens when the economy is flooded with money and people and borrowing and buying?, well the buying power drops, (ie inflation kicks in) and so the central bank has to slow down the economy again.

Interest rates go up, thus pushing the cost of money higher, people stop borrowing funds become harder to secure.

At the same time the Reserve bank increases their reserve requirements for deposits. What this does is reabsorb that extra cash that was flooded into the economy. This reduces the amount of cash in circulation and this increases the buying power of the dollar again.

If you think about it, then it doesnt matter what the interest rates are. Because if you've found a bargin then it doesnt matter what cycle the economy is in, since all it really is is a manupulation of the central bank.

Anyway, I could be wrong, if so please clarify it for me, as this makes up a little of my paradigm :)

Michael G.
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Reply: 2.1
From: Todd Cameron

As was said above, interest rates are really just representative of the 'cost' of money. In a low interest environment people tend to be more adventurous with their investing (as seen in people accepting lower IP yields on the basis of future capital gains).
Interest rates matter because they are the cost of money to your investment and of course the cost in any venture can kill you if they are sustained and high.
Interest rate predictions matter for naught as they are the only values you know will NOT be true. However you must manage your costs and interest rates are the biggest cost. The need to manage risk varies amongst us. Essentially that means you must manage risk to 'sleep at night' and thus fixing rates where YOU feel comfortable.
Actually inflation goes back to the times of 'intrinsic value' coins-i.e. silver/gold coins whereby people would 'skim off' some of the metal around the edge of the coin thus devaluing coins as they are circulated(the concept of inflation is diminished purchasing power over time). The ridge on the edge of coins was integrated to curtail this behavior.
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Reply: 3
From: Jas

Last month Macfarlane made a speech at the Tas uni. He basically answered these qs:
Why does the Reserve Bank have to change interest rates at all: why can’t they be left constant?
Why does the Reserve Bank have to be involved in the first place: why can’t the determination of interest rates be left to the market?
Why do we need to set our own interest rates in Australia: why can’t we just accept the rates of another country, e.g. the United States?
You can read his speech here

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