Question

(a) James is applying for a new home loan. He wishes to borrow $250,000 and make his repayments monthly. The interest rate the bank has quoted him is 4% per annum. 1. Is this the real rate of interest or the notional rate of interest? 2. Explain the difference between the real rate of interest and the notional rate of interest. 3. Calculate the real rate of interest and the notional rate of interest for James. 4. Is it possible for the real rate of interest to equal the notional rate of interest? Explain. (b) The Reserve Bank of Australia has announced a 0.25% decrease in the cash rate. What effects does this have on the economy and the financial markets? Provide examples of who might benefit from this decrease and those that do not.

Answer 1

Answer to (A) Part 1:

The interest rate of 4% per annum is the notional rate of interest. Banks usually charge notional rate of interest on their loans.

Answer to (A) Part 2:

Notional Interest Rate or Nominal Interest Rate is Inflation un-adjusted(does not take into account) Interest Rate.On the other hand, Real Interest Rate is Interest Rate adjusted for Inflation..

Nominal Interest Rate cannot be negative but Real Interest Rate can be negative when the inflation exceeds the nominal interest rate.

Answer to (A) Part (3)

The notional interest rate for James is the interest rate being quoted by the bank.Here the interest rate is 4% per annum. But James will have to make repayments monthly so the monthly notional interest rate will be: 4%/12 ie. 0.33%

Real Interest Rate= Nominal Interest Rate-Inflation .

Since Inflation rate is not given in the question: Real interest Rate cannot be calculated.

Answer to (A) Part (4):

It is possible for the Notional Interest Rate and Real Interest Rate to be equal in case there is zero inflation or the economy is not experiencing any inflation(in reality almost impossible).

Answer to (B):

Let us first understand what is Cash Rate.Cash Rate refers to the interest rate that the Reserve Bank of Australia offers its commercial banks on overnight loans when they lend to each other.

Impact of Cash Rate on the Economy:

When the Reserve Bank of Australia lowers the cash rate (as is the case here) it leads to a fall in all other interest rates(as it is a benchmark rate) .Lowe interest rate stimulates spending by increasing the amount of funds available in the hands of the consumers.The companies will respond to this increased spending by increasing their production thereby leading to an increase in economic activity and ultimately the employment.

Impact of Cash Rate on the Financial Markets:

The Financial market Volatility increases on the day of the announcement of the changes in the cash rate(in this case a decrease) but goes back to the pre-cash rate change levels.

Who benefits from a decline in the cash rate?

All home buyers or home mortgage holders with variable mortgage rates are benefited by a decrease in the cash rate as a decrease in the cash rate will translate to lower mortgage and home loan rates.

Who does not benefit from a decline in cash rate?

Mortgage holders with fixed rate,old mortgage holders with the old cash rate before the decrease will not benefit as they will have to pay at a