Question

Given a nation has very high household debt, what implications would an increase or decrease in cash rate have on the overall economy?

Answer 1

Cash rate is the rate of interest at which the central bank of a country provides loans to the commercial bank of that country.

Suppose such rate increases. It reduces money supply in the economy, since as the cash rate increases there would be higher interest rates on debts by commercial banks to households; this decreases consumption spending (C), which is a component of GDP. It decreases GDP of the country as well as the rate of inflation but increases unemployment. Central bank may increase the cash rate as a part of contractionary monetary policy.

Again, if the cash rate decreases, there would be an increasing money supply in the economy. It happens because of charging lower interest rates by commercial banks to debt-holders. This increases C, since interest obligation has been reduced; more spending means more GDP in the country, which reduces unemployment but increases inflation in the economy. This is a policy tool (monetary) of central bank on the hope of expansion.