Ok... I don't really understand how the whole thing works. Just one question is bugging me.
Say the Reserve bank increase the rate from 2.5% to 3%. Who gets to keep that extra 0.5%?!?
ok two questions. We borrow from banks. Banks borrow from big banks. Where do those big banks get money from? China?!?
Ask Ross Gittins
Every bank has an account with the Reserve called its ''exchange settlement account''. Just about every monetary transaction in the economy goes through these accounts. As Debelle explains, when you pay your electricity bill by direct debit, the funds are effectively transferred from your bank account, across the exchange settlement account of your bank to that of your electricity company's bank and into the electricity company's account.
All these transactions mean the balance in each bank's exchange settlement account goes up and down throughout the day. But the Reserve requires each bank to ensure its account always has a positive balance. Banks that leave funds in their account overnight are paid interest at a rate 0.25 percentage points below the cash rate, whereas banks that look like having a negative balance may borrow the difference from the Reserve overnight at a rate 0.25 percentage points above the cash rate.
Get it? These penalties are designed to encourage the banks to borrow and lend to each other overnight at the (more attractive) cash rate.
The Reserve's ability to control the cash rate arises because it has complete control over the supply of funds in this market. It ensures there is just sufficient supply to meet the demand for funds at the interest rate it is targeting.
Where an increase in demand threatens to push the interest rate up, it will use its ''open market operations'' to increase the supply of funds just sufficiently to keep the rate where it wants it. Where a fall in demand for funds threatens to push the rate down, the Reserve will reduce the supply to ensure the rate doesn't change.
Historically, the Reserve would increase the supply of cash by buying second-hand government bonds from the banks and paying for them with cash. (Note that in this context, ''cash'' doesn't mean notes and coins, it's a nickname for the funds in exchange settlement accounts.)
Conversely, it would reduce the supply of funds by selling bonds to the banks, which they had to pay for from their exchange settlement accounts. These days, however, the Reserve achieves the same effect using repurchase agreements (''repos'').
The main reason for fluctuations in the overall daily demand for exchange settlement funds is transactions involving the Reserve's one big banking customer, the federal government.
Demand will rise on days when the government's receipts from taxation exceed its payments of pensions and all the rest. Demand for cash will fall on days when the government's payments exceed its receipts.
All this ensures the Reserve has a vicelike grip on the cash rate. And this gives it the ability to influence all the other interest rates in the economy. Why? Because the cash rate is, in effect, the anchor point for all other rates.
Banks fund only a very small part of their operations in the cash market, Debelle explains, but all their funding could be done from that market if they wanted to.
The rate at which they're prepared to borrow for periods longer than overnight is the averaged expected path of the cash rate over the life of the loan plus various margins for risk.
If this were not the case, a bank would be better off borrowing all the funds it needed in the overnight cash market and rolling them over every day.
The reason banks borrow and lend at rates higher or lower than the average expected cash rate over the life of the loan is the need to allow for the various risks involved (the risk of not being repaid, the risk in agreeing to lend your money for a longer time, and so forth) and, of course, profit margins along the way.
For several years leading up to the global financial crisis, these various margins (known as ''spreads'' or ''premia'') didn't change much, meaning a change in the cash rate brought about an identical change in mortgage and other bank lending rates.
Since the crisis, however, margins have been changing a lot, as a result of people realising they weren't charging enough to cover the risks they were running, and our banks realising they needed more domestic, retail and longer-term funding to protect them against future crises, leading to intense competition between them to attract term deposits.
