These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds. If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. The actual level of the cash rate, which results from the Reserve Bank's market operations, as well as the target rate are shown in Graph 3. The transmission of monetary policy to the economy Graph 4 Click to view larger Graph 5 Click to view larger Movements in the cash rate are passed through quite quickly to the whole structure of deposit and lending rates, however changes in these interest rates affect economic activity and inflation with much longer lags. This is because it takes time for individuals and businesses to adjust their behaviour.
Interest rates affect economic activity via a number of mechanisms.
They can affect savings and investment behaviour, the spending behaviour of households, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand. Developments in aggregate demand, in conjunction with developments in aggregate supply, in turn have an effect on the level of inflation in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy. In describing the different ways in which monetary policy affects the economy, it should be kept in mind that they are far from being purely mechanical in their operation. The smaller interest rate rises in 1994 were similarly followed by an easing in demand growth and inflation.