1
Q
What is monetary policy?
A
Refers to the interest rate decisions taken by the Reserve Bank of Australia to affect monetary and financial conditions within the economy, with the aim of achieving low inflation (price stability) and sustainable economic growth.
2
Q
Financial markets
A
- Act as intermediaries between savers and investors
- E.g. financial institutions such as banks
- Borrow from firms or individuals with excess funds and lend to those who need funds
3
Q
Main types of financial markets
A
Loan market
Bond market
Share market
4
Q
Loan market
A
Business firms borrow money to buy capital equipment while households borrow for housing and cars
5
Q
Bond market
A
Firms and governments sell bonds to raise finance (e.g. to finance a budget deficit
6
Q
Share market
A
Firms can obtain finance for expansion by issuing new shares though the stock market
7
Q
Key functions of money
A
- Means of exchange
- Unit of measurement
- Store of value
8
Q
Main goal of the RBA
A
- Price stability
- Keeping inflation low to protect the value of money and promote stability in the financial system
9
Q
What do interest rates represent?
A
- Represent the price of credit and the cost of borrowing money over a period of time
- Equates to the demand and supply of funds
- A large proportion of transactions are based on credit and borrowing, therefore changes in interest rates have a significant impact on the level of spending and economic activity
10
Q
Nominal vs real interest rates
A
- Nominal rates: not adjusted for inflation
- Real rate: nominal rate minus the inflation rate
o Important influence on economic conditions involving borrowing and saving
o Shows how much borrowers actually pay and how much lenders receive in terms of purchasing power - Nominal rates tend to reflect changes in inflation
11
Q
Why do the rates offered by the financial institutions to lenders will be much less than the rates charged by the same institutions for loans
A
- A major portion of the firms’ costs (including profit) are met by this differential
- Interest rates vary due to the reasons associated with the risk and maturity period of any given loan
- Risk arises because the future is uncertain
12
Q
Long term/ short term interest rates
A
- Long term interest rates are usually higher than short term rates, because lenders need to be compensated for parting with their funds over a longer period
- A longer loan period equates with greater risk and greater uncertainty and therefore the interest rates should be higher than for a short term loan
13
Q
Demand for loanable funds (DLF)
A
- The higher the real interest rate, the smaller the quantity of loanable funds demanded
- This is because the real interest rate represents the opportunity cost of funds
- Firms will be willing to demand more funds for investment at a lower real rate of interest
- ↑ rate, ↑ cost of borrowing, ↓ demand for loanable funds
14
Q
Supply of loanable funds
A
- Main source of loanable funds is from saving
- As the real interest rate rises, there is more incentive to save
15
Q
Factors that could increase the demand for loanable funds
A
- An increase in economic activity
- A government budget deficit
16
Q
Factors that could decrease the supply of loanable funds
A
- A decrease in private saving
17
Q
Factors that could decrease the demand for loanable funds
A
- A decrease in economic activity
18
Q
Factors that could increase the supply of loanable funds
A
- Government budget surplus
- An increase in private saving
19
Q
Aim of monetary policy
A
To achieve a sustainable growth rate in the long run by controlling inflation
20
Q
Relationship between low inflation, economic growth and full employment
A
- Inflation reduces the value of money and undermines the confidence of households and firms
- High levels of inflation can have a negative effect on economic growth and living standards
- This is why low inflation is seen as a vital objective in achieving long term economic stability
21
Q
Objectives of monetary policy
A
- Stability of the currency of Australia
- Maintenance of full employment
- Economic prosperity and welfare of the people of Australia
22
Q
Benefits of low inflation
A
- Maintains the real value of money
- Protects the value of savings
- Keeps nominal and real interest rates low
- Promotes business confidence and productive investment
- Reduces uncertainty which promotes long term growth and job creation
- Promotes international competitiveness
- Does not distort income distribution
- Improves decision making
23
Q
Costs of high inflation
A
- Rising unemployment
- Stagnant economy (stagflation)
- ↑interest rates which reduces private sector spending and ↓economic growth
- Reduces international competitiveness
24
Q
Target inflation rate
A
2-3%
25
Ways the inflation rate can be measured
- Headline rate
| - Underlying rate
26
The headline rate
The most common rate and is measured by the consumer price index
27
Underlying rate
Measures the headline rate minus volatile and seasonal elements. It is meant to provide a more accurate measure of inflation
28
How does the RBA calculate its own measure of underlying inflation?
- Trimmed mean
- Weighted median
- Averaging techniques which eliminate the top and bottom of the CPI
- Approximate estimate of the ‘true’ inflation rate
29
What does the RBA need to be aware of?
- Changes in a number of leading economic indicators to assess the strengths and weaknesses of the economy and the position the economy will be in, in six to twelve months
- Monitors
o Changes in wages
o The retail sector
o The labour market
o The housing sector
o Business investment
o The exchange rate
o The terms of trade
o The balance of payments
o The national accounts
o International economic data
30
Why is monetary policy is forward looking?
- Because the reserve bank’s actions will affect the economy in six to twelve months’ time
31
First Tuesday of each month
- Reserve Bank Board meets
- Reserve Bank Staff briefs the board on current economic conditions, after which the board announces what the target cash rate will be for the next month
32
Open market operations to tighten monetary policy
- Open market operations consist of buying or selling Australian government securities
- The RBA enters the money market to create a shortage of cash by selling securities
- This will increase the price of cash and cause other short and long term interest rates to rise
- If the cost of borrowing increases, then the demand for credit will decrease and private spending in the economy will also increase
- Therefore, the monetary stance is said to tighten
33
Open market operations to loosen monetary policy
- Create a surplus of cash by buying securities
- This will decrease the price of cash and place a downward pressure on interest rates charged by banks and other financial institutions
- This decreases the cost of borrowing and increases the demand for credit
- Spending and economic activity will expand
- Therefore, monetary policy adopts an expansionary stance
34
What is the transmission mechanism?
How interest rates affect economic activity
35
What do changes in the cash rate influence?
The expectations of the private sector and affect the level of domestic demand in the economy
36
Changes in the interest rates affect:
- Saving and investment decisions
- The cash flow of households and firms
- Wealth and asset prices
- The exchange rate
37
Interest rates affect households’ decisions to save
- A rise in interest rates will increase the incentive to save because it will increase the return on deposits with financial institutions
- At the same time, increased interest rates increase the cost of borrowing funds and reduce spending by households and reduce demand for finance
38
How do changes in interest rates affect business decisions
- Businesses often borrow to invest
- An increase in interest rates will reduce the demand for investment funds because it will affect the profitability of many investment projects
- Firms also have less cash to pay expenses and are not likely to expand production or increase employment
39
Affect the cash flow of households and firms
- A rise in mortgage rates for example, will reduce the amount of income available for households to spend on other goods and services
- Most firms are net borrowers, which means that interest payment on their overdraft and loan accounts represent a significant portion of their profits
40
Affect wealth and asset prices
- A rise in interest rates makes shares less attractive compared to bonds and this leads to a fall in the stock market
- Share prices begin to decline, which lowers the wealth of households with share portfolios and ultimately will lead to a decrease in spending
- ↓ asset price, ↓ people’s wealth
41
Affect the exchange rate
- A fall in interest rates will reduce capital inflow which will reduce the demand for currency
- This will lead to a depreciation
- A lower exchange rate will decrease export prices and increase import prices
- This will increase net exports and raise total spending in the economy
- It is therefore quite powerful under a free exchange rate
42
The intention of a contractionary monetary policy
- A rise in interest rates will help to prevent the economy from overheating and stop inflation from rising above the target threshold (2-3%)
43
How do interest rates have a contractionary effect on the level of AD
- High interest rates will have a dampening effect on private spending, especially durable consumption and investment spending
- This will increase the cost of borrowing funds and reduces the level of disposable income of households and the cash flow of firms
- Mortgage payments represent one of the major items of household expenditure, so small changes in interest payments can have a significant effect on monthly repayments
- Credit card repayments will also be affected by changes in interest rates and impact on a household’s budget
- Also cause a currency appreciation
44
How do interest rates have an expansionary effect on the level of AD
- Low interest rates decrease the costs of borrowing funds and increase the level of disposable income of households and the cash flow of firms
- Encourages households and firms to increase their borrowing and current expenditure
- AE↑, which will raise the economy’s growth rate
- ↑the level of output, employment and income
- Causes our currency to depreciate
45
RBA adopting a ‘neutral’ stance
- It means setting interest rates at a level that is stimulatory nor contractionary
- A neutral stance implies neither a positive nor negative influence on the economy e.g. 2010 when the cash rate was between 4-4.5%
46
What is inflation targeting?
Established with the ‘statement on the conduct of monetary policy’ – 1996
- Setting out the Bank’s inflation objectives
- Recognition of the reserve bank’s independence in setting monetary policy
47
Transparent policy
- Important to announce and explain its policy decisions
- Open about the nature and direction of policy
- Helps to make monetary policy more effective in controlling inflation and influencing economic activity
48
How is inflation is a leading indicator?
- If prices rise, it tends to indicate that the economy is starting to accelerate
- The reserve bank will consider raising the cash rate
- When inflation falls, it is usually a sign that the economy is weakening
49
Main strengths of monetary policy
- Flexibility
- Political neutrality
- Effectiveness in booms
- Effectiveness when used in conjunction with a floating exchange rate
50
Flexibility of monetary policy
- Decisions about whether to raise or cut the cash rate are made every day by the RBA
- Changing the cash rate does not require authorisation by Parliament
- Decision and action time lags for monetary policy are relatively short compared with monetary policy
51
Political neutrality of monetary policy
- The RBA is an independent authority and is not aligned to the government in power
- The cash rate affects every sector of the economy, and people tend not to see the policy as particularly aimed at them
- Independent of the political process
- Decisions are based on economic rather than political reasons
52
Monetary policy's effectiveness in booms
- More effective in the control of high levels of AD and inflation, than during the recession phase of the business cycle
- Tighter monetary policy is more effective than loose monetary policy
- Higher interest rates have a more direct effect on economic decisions than do lower rates
- Important role in the decisions of consumers who have to borrow or investors comparing likely rates of return
53
Effectiveness of monetary policy when used in conjunction with a floating exchange rate
- Changes in interest rates and the interest rate differential will affect the movement of financial capital in and out of the economy
- ↓interest rates will ↓capital inflow, leading to a depreciation
- Net exports will be stimulated as export prices fall and import prices rise
- This expansionary monetary policy will not only increase consumption and investment, but will increase net exports.
54
Main weaknesses of monetary policy
- Longer outside lags
- Effectiveness in a recession
- Cannot target particular groups
55
Monetary policy has longer outside lags
- The effect lag for monetary policy is longer than for fiscal policy
- This is because monetary policy works indirectly through interest rates to affect AD
- Fiscal policy works more directly and affects AD more quickly
56
Monetary policy's effectiveness in a recession
- Low rates may not be sufficient to stimulate private spending when economic activity is low
- E.g. the cash rate could be 3% or less, but if the investor does not expect favourable economic conditions in the future, then they may not choose to borrow, even if the cost of borrowed money is relatively low.
57
Monetary policy cannot target particular groups
- Cannot be used selectively to target particular groups or sectors in the economy
- Changes in interest rates affect everyone, and it is often referred to as a blunt policy
Economics ATAR
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