Question

If there is excess supply of funds in Banks’ exchange settlement accounts, explain what the RBA would do to ensure that the cash rate of interest remains constant.

Answer 1

When there is excess supply of funds in Banks' exchange settlement accounts, the cash rate of interest will tend to decrease because of the theory of demand and supply. in this scenario, the supply of funds becomes greater than the demand for funds by commercial banks. Hence, the price of funds i.e the cash rate decreases. In order to keep this constant at the level prior to eexcessive funds, the RBA can take measures such as open Market operations. RBA lends money to the commercial banks in case of overnight needs or emergencies. But it can also perform other roles when it has excess money supply. RBA can perform open market operations where it can buy government securities in the open market in exchange for excess funds till the point the cash rate of interest comes to the original level. In this way, the excess funds which the Reserve bank had can be transferred to the general public. This reduces the supply of funds and reaches the target level of liquidity, thus balancing the supply and demand by commercial banks and keeping cash rate of interest at an equilibrium. In the above diagram we can see that the equilibrium cash rate is the target rate(T) ,if supply exceeds demand the price decreases. To maintain the level of cash rate the supply has to decrease.