Have you ever wondered what the Reserve Bank of Australia (RBA) is doing when they increase interest rates?

The bottom line, to use a catchphrase, is that every type of investment is related to the cash rate set by the RBA.

To make a very simplistic observation the interest rate which the RBA sets is a tool which is used to fine tune investments and therefore the flow of cash from one sector of the economy to another. In any economy the flow of cash dictates the movement into or out of investments. For example, to housing, to shares, IBD’s, superannuation

Currently the RBA has set the cash rate at 4.5% which means that by putting cash into a savings account, at simple interest it would take 22.22 years (100/4.5=22.22) to double in value. That figure of 22.22 is the P E ratio for cash at the RBA rate.

The P E ratio equates to the number of years that it will take to repay the capital, without taking into account growth or inflation.

If you shop around and receive say 5.4% interest then the P E ratio will be 18.52 (100/ 5.4= 18.52).

Why do other institutions offer more than the RBA cash rate? They know that there has to be an incentive for you to move money to them and they can use this money to invest to make a profit.

For shares there is the factor of dividend yield to repay purchase price. A share with a P E ratio of 16 would be paying a dividend yield of 6.25% (100/6.25 = 16)

So an investment with a P E of 16 (years) is much better than one with a P E of 22.22 (years). But then you have to weigh up the risks and consider your personal circumstances.

As I said this is a very simplistic explanation. In reality such factors as the risk of investment, income tax, currency movements and inflation will also be considered before there is a decision to invest.

This is how the RBA is able to control inflation by encouraging or restricting the flow of money to a particular investment sector.