Research Discussion Paper – RDP 9504 The Link between the Cash Rate and Market Interest Rates Abstract

This paper explores the relationship between the cash rate and interest rates set by financial intermediaries and interest rates set in auction markets. It presents estimates of the average degree of pass-through of cash rate changes to these other interest rates. It also presents a model of the spread between banks' lending rates and the cash rate, and then uses the model to analyse developments in bank lending spreads over recent years.

The paper argues that while banks' average lending spreads did not widen in the early 1990s, the margin between lending rates and the cash rate did increase. It examines the reasons for this change, paying particular attention to the roles played by changes in the structure of banks' liabilities, changes in default probabilities and changes in the degree of competition. The large lending spreads at the margin have led to intensification of competition, particularly in the market for housing loans. While these competitive pressures took some time to emerge, they are now playing a role in the narrowing of margins.

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