The reason the Reserve Bank Of Australia (RBA) reduced the cash rate by 25 basis points from 5% to 4

Therefore the RBA cut the cash rate as a pre-emptive strike against the likelihood of falling aggregate demand and a slowdown in economic growth in the Australian economy.

A reduction in the cash rate by the RBA , indirectly reduces other interest rates, which has an expansionary effect on the economy increasing aggregate demand. The idea behind the rate cut is...."to give Australia a cushion to help continue the Australian growth in a very uncertain world". [AFR 6/9/01]

A reduction in interest rates will increase aggregate demand and boost economic growth through the following ways:

A reduction in interest rates (i/r) will reduce the cost of borrowing for business investment, makes business ventures appear more profitable, increases investment=>AD & AE. Also lower i/r's signals price stability and less chance of inflationary pressures being a concern in the economy, which also increases the likelihood of investment being undertaken by businesses.

A reduction in i/r's will reduce mortgage repayment loans, therefore increasing the consumer's level of disposable income=> increasing C=> increasing AD & AE.

A decrease in i/r's will cause foreign investment funds to be withdrawn from Australia (capital outflow) which results in a decrease in the demand for the Australian dollar ($A), therefore depreciation of $A. The depreciation of $A results in increased levels of export income, because more $A are received when converted from $US, increased export income=>increased AD & AE. Also depreciation of $A makes imports more expensive, resulting in import-competing industries (ici's) demand increasing, as domestic demand increases=> increased C=>increased AD & AE.

The RBA therefore cut the cash rate to offset the expected decrease in aggregate demand and to increase aggregate demand to promote continued economic growth within Australia.

The Effects Of A Reduction In Interest Rates On

Aggregate Expenditure And Aggregate Demand.

Other reasons for the RBA's cut in the cash rate by 25 basis points is because Falling levels of employment growth and a forecasted higher unemployment rate of around 7%, indicates expansionary monetary policy is needed to avoid rising levels of unemployment in the Australian economy.

The RBA doesn't seem to be concerned about the level of inflation or inflationary expectations in the economy, even with the booming housing sector, strong growth in retail sales and nominal growth in weekly wages. With the attraction of lower mortgages predicted to push up asset prices, as the demand for houses increases due to lower i/r's, inflationary expectations still remain low. In the area of Fiscal Policy, the introduction of the GST has created additional tax revenue for the government intent on achieving Fiscal consolidation, which reduces demand-pull inflationary pressures in the economy. The RBA feels it will be able to maintain low inflation also due to downward pressures from a weakening export sector and global economy. The depreciation of the Australia dollar due to the rate cut will naturally cause imported inflation but that will be more than off-set by a slowdown in expected export growth. The RBA is focused on reducing the expected size of fluctuations in output, rather than focus solely on inflation.

All these signs point the RBA to cut the cash rate by 25 basis points to 4.75%.

BIBLIOGRAPHY

The Australian Financial review, 6/9/01

Economic Insights, Tibbet Andrew. Longman Australia 1999

www.rba.gov.au

www.abs.gov.au (for statistical comparison of labour wages)

Macroeconomics, Crompton Paul. Nelson 2001