Activity 9b: The neutral interest rate
- The neutral cash rate is the level of the cash rate that it is neither working to stimulate nor contract the economy. It is the cash rate that prevails when internal stability is achieved and the cash rate is neither stimulating nor contracting the economy.
- The nominal cash rate is the actual cash rate that exists at any given time, where is the real cash rate is the nominal cash rate adjusted for the rate of inflation. For example, if the nominal cash rate is 10% and the rate of inflation is 6% then the real cash rate is 4%.
- It is not fixed because there are various factors, both domestic and global, that will influence the degree or extent to which any given level of interest rates will impact on aggregate demand and economic activity. For example, if there was a large decrease in competitive pressures within financial markets (such as one of the major banks taking over two or three of the others), This would exert upward pressure on market rates of interest, widening the difference/margin between the cash rate and general interest rates. In this environment, the pre-existing neutral rate would no longer be one that has a benign impact on the economy and, instead, it will be consistent with general interest rates that are restricting the economy. Accordingly, the RBA would need to reduce the cash rate by more than before in order to stimulate the economy and the neutral rate must fall.
- If inflationary expectations increase to very high levels then it would exert upward pressure on the nominal neutral rate of interest. This is the because the real neutral rate is a minimum of 0 (or somewhere between 0% and 1%), with the addition of a margin determined by medium term inflationary expectations. Accordingly, if inflation is expected to reside at 10% then the nominal neutral rate must be at least 10% (to ensure that the real neutral rate is at least zero).
- If productivity growth falls to very low levels, let’s assume 0%, then it will cause the nominal neutral rate to fall. This is because any given level of the nominal cash rate will be acting to restrain growth in the economy relative to before; or a lower cash rate than before will be needed to expand the economy given that productivity growth is absent.
- If borrowers become much more risk averse, it means that they will be less willing to borrow money. In this environment, the nominal neutral rate of interest will fall because interest rates would need to be lower than before in order to exert a stimulatory/expansionary effect on the economy.
- An increase in lenders relative to borrowers in the economy will exert downward pressure on market rates of interest over time and cause the nominal neutral rate of interest to fall. This occurs because any given level of interest rates needs to be lower in order to encourage any given level of consumption and/or investment.