Interest rates: everything you need to know

Its time to stop faking when the finance news comes on ? here, finally, is a simple explanation of why the RBA sets interest rates.

Its the first Tuesday of the month and that means the RBA board is going to put their well-paid heads together and think about changing interest rates.

On the evening news, the finance guy will discuss whether interest rates went up, down, or stayed the same, and 90 per cent of people will cover their uncertainty about what it all means by nodding wisely.

Well, no more. Heres what the RBA does at its famous board meetings ? and more importantly, why.

The RBAs main job is to target inflation, so annual average price rises stay roughly between 2 and 3 per cent. Theyve been aiming for that since the early 1990s and have become pretty good at it.

rba target band and inflation

The RBA:

? raises interest rates to stop inflation getting too high;
? cuts rates to stop inflation getting too low.

Why worry so much about inflation? Partly because stable prices make the economy run smoothly. (Zimbabwes inflation problems ? where you need a brick of cash like the bloke in the photo on the right to buy anything ? are best avoided.)

But mainly because managing inflation controls unemployment and economic growth pretty effectively.

Low inflation and unemployment tend to happen at the same time, for the same reason: a slowing economy.

If you cut interest rates, the economy gets a little boost, inflation pops up and unemployment slowly goes away again.

At the other end of the spectrum, sometimes the economy is growing too fast ? producing inflation but not extra employment. Then the RBA may raise rates to cut inflation.

So there it is: The RBA moves interest rates to target inflation, because thats what keeps our economy growing and makes sure we all have jobs. Easy!

If youre still reading, kudos. Youre the sort of smart person who wants to know how things work. So here we go with a special serving of extra elements for the intellectuals.

The official interest rate affects inflation in many ways. Heres the top three:

1. Spending vs Saving

If interest rates are high, people save more and spend less. Also, people with variable rate mortgages have to pay more to the bank each month. This means less money being spent in the economy, so shops cant easily put their prices up.

2. Loans

If interest rates are high, people and businesses take out fewer loans. This means people build fewer homes, businesses decide not to invest in a factory, etc. There is less being spent in the economy, so less chance of price and wage rises.

3. The Aussie dollar

If our interest rates are high, overseas investors are more likely to invest cash in Australia. When they do that, they have to buy Aussie dollars, and the value of the dollar goes up. When the currency is higher, imports become cheaper, and inflation falls.

There you have it. You now speak the language of monetary policy!

Beware though. If you try to impress your friends with your newfound expertise over drinks, you tend to not get invited to drinks all that often. Take it from experience

Source: The New Daily

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