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Flashcards in Chapter Fifteen Deck (19):
1

What are the monetary policy objectives

Objectives set out in the reserve bank act 1959. The reverse bank act requires the bank to conduct monetary policy in a way that will best contribute to the objectives of 1. The stability of the currency of Australia, the maintenance of full employment in Australia and the economic prosperity and welfare of the people of Australia.

2

Explain stability of currency

Might mean a stable exchange rate between Australian dollar and other currencies or it might mean a stable price level so that the currency has a stable purchasing power. The reverse bank uses the latter thus stable prices and stables purchasing power of money. The second and third objectives are taken to mean not only achieving full employment but also minimising business cycle fluctuations. Reserve bank places primary emphasis on price stability as it is necessary for achieving full employment and moderate business cycle fluctuations. That is the reserve banks job is to control the quantity of money and interest rates in order to abound inflation and prevent excessive swings in real GDP growth and unemployment. This emphasis on inflation has been made concrete by an agreement between and a joint statement by the reserve bank and the commonwealth government

3

Explain statement on the conduct of monetary policy

The reserve bank and the gov agree on the goal of keeping consumer price inflation between 2 and 3 per cent, on average, over the business cycle. Consumer price inflation is defined as the rate of increase in the trimmed mean CPI. The reserve banks goal is to keep the rate of growth of the trimmed mean CPI inside the 2-3 per cent a year range on average over the business cycle. But the reverse bank is willing to go outside that range in short run to stabilise the business cycle. A monetary policy strategy in which the central bank commits to an explicit inflation target and to explaining how it's actions will achieve that target is called inflation targeting.

4

Explain the rationale between the inflation control target

Two main benefits flow from adopting an inflation control target:

The reserve banks policy actions are more clearly understood by financial market traders so that savers and investors experience fewer suprises and make fewer mistakes.

The target provided an anchor for expectations about the future inflation a

Firmly held expectations of low inflation:
Make the short run output inflation trade off as favourable as possible
Allow better economic decisions which in turn help to achieve a more efficient allocation of resources and more stable economic growth

5

Explain support and criticisms of the inflation control target

Critics argue that by focusing on inflation the reserve bank might raise the interest rate, lower investment and exports and with a multiplier effect decrease aggregate exports and with a multiplier effect decrease ad and push the economy into recession

Supporters say that by keeping inflation low and stable monetary policy makes its maximum possible contribution towards achieving full employment and sustained economic growth

6

What the prerequisite for achieving the goals of monetary policy

The global financial crisis brought the problem of financial instability to the top of the agenda of the worlds central banks. To pursue financial stability, the reverse bank along with the government have developed so called macro prudential regulations designed to avoid a repeat of the recent crisis. The pursuit of financial stability is a prerequisite for achieving the goals of a stable currency and full employment

7

What is the responsibility for monetary policy

The reserve bank act places responsibility for the conduct of monetary policy on the reserve bank board. The reverse bank board consists of the governor or chairman, the deputy governor, the secretary to the treasury, six enteral members. The act requires regular consultations on monetary policy between the governor and the treasurer

8

What is a monetary policy instrument

Is a variable that the reserve bank can directly control or closely target and that influences the economy in desirable ways. The reserve bank can fix either the quantity of monetary base or the price of monetary base. Monetary base has two prices: it's price in the foreign exchange market, the exchange rate and its price in the interbank overnight loans market which is the cash rate

9

Reserve bank and cash and exchange rate

The reserve bank can set the monetary base, the exchange rate or the cash rate but it can set only one. If the reverse bank decreases the quantity of monetary base, both the cash rate and the exchange rate rise. If the reserve bank wants to raise the cash rate, the quantity of monetary base decreases and the exchange rate rises. If the reverse bank lowers the exchange rate, the quantity of monetary base increase and the cash rate falls. The reserves banks choice of monetary policy instrument is the cash rate. Given this choice the reserve bank permits the exchange rate and the quantity of monetary base to find their own equilibrium values.

10

Explain the instrument rule

An instrument rule is a decision rule for monetary policy that sets the policy instrument by a formula based on the current state of the economy. The best known instrument rule for the cash rate is the Taylor rule. The Taylor rule sets the cash rate by a formula that links it to the current inflation rate and current estimate of the output gap.

11

Explain the targeting rule

A targeting rule is a decision rule that sets the policy instrument at a level that makes the central banks forecast of the ultimate policy goals equal to their target. After announcing the target cash rate decision. The reserve bank explains the reason for its decision. Four times a year the reserve bank published a detailed statement on monetary policy that describes the forces operating on the economy, the outlook for inflation and real GDP growth and the reasons for its target cash rate.

12

How does the reserve bank hit the cash rate target

Banks reserves on deposit at the reserve bank called exchange settlement balances, are the deposit accounts that banks use to make inter bank transactions. The reserve bank pays interest on these accounts equal to the cash rate target minus 0.25 per cent. A banks alternative to holding reserves on deposits at the reserve bank is to lend them overnight to another bank. The interest rate earned on overnight loans in the interbank market is the cash rate. Because a bank can earn the cash rate target minus 0.25 per cent t on exchange settlement balances it will never lend funds to another bank for less than this rate. So the interest rate in exchange settlement balances puts a floor on the cash rate. The cash rate can't fall more than 0.25 percentage points or 25 basis points below the cash rate target. To hit the cash rate target the reserve bank conducts open market operations until the quantity of reserves is just the right quantity to hit the cash rate target. When the reserve bank changes the cash rate, events ripple through the economy and lead to the ultimate policy goals eg interest rate changes, money and bank loans changes and the long term interest rate changes plus expenditure plans

13

How does the reserve bank fight recession

If inflation is below target and real GDP is below potential GDP, the reserve bank takes actions that are designed to restore full employment. The reserve bank board lowers the cash rate target from 3 per cent to 2 percent a year. The reserves bank buys securities on the open market which increases the quantity of bank reserves to hit the cash rate target. In the money market, the supply of mine increases and the short run interest rate falls from 3 percent a year to two per cent a year and the quantity of real money creases. In the market for loan able funds an increase in the quantity of loans increases the supply of loan able funds, the real interest rate falls and the quantity of investment increases. The final ripple effect closes the recessionary gap. An increase in expenditure increases ad by increased expenditure. A multiplier effect increases ad to ad1. Real GDP increases and the recessionary gap is eliminated

14

How does the reserve bank fight inflation

If the inflation rate is too high and real GDP is above potential GDP, the reserve bank takes action to lower the inflation rate and restore price stability. The reserve bank board raised the cash rate target from 3 per cent to 4 percent a year. The reserve bank sells securities on the open market which decrease the quantity of bank reserves to hit the cash rate target. In the money market, the supply of money decreases and the short run interest rate rises from three per cent a year to four per cent a year and the quantity of real money decreases. In the market for loan able funds, a decrease in the quantity of loans decreases the supply of loan able funds and the real interest rate rises and the quantity of investment decreases. The final ripple effect closes the inflationary gap. A decrease in expenditure decreases ad by increased expenditure and the multipler effect decreases ad. Real GDP decreases and the inflation slows.

15

Explain the loose links from cash rate to spending

The long term real interest rate that influences spending plans is linked only loosely to the cash rate. Also the response of the long term real interest rate to a change in the nominal rate depends on how inflation expectations change. The response of expenditure plans to changes I. The real interest rate depends on many factors that make the response hard to predict

16

Explain the time lags in the adjustment process

The monetary policy transmission process is long and drawn out. Also the economy does not always respond in the exactly same way to a given policy change. Further, many factors other than policy are constantly changing and bringing new situations to which policy must respond

17

Explain final reality check

The time lags in the adjustment process are not predictable but the average time lags are known. After the reserve bank takes action, real GDP begins to change about one year later and the inflation rate responds with a lag that averages around two years. This long time lag between the reserve banks action and a change in the inflation rate, the ultimate policy goal, makes monetary policy very difficult to implement

18

Explain money targeting

An example of friedmans k per cent rule. The k per cent rule is a monetary policy rule that makes the quantity of money grow at k per cent year where k equals the growth rate of potential GDP. Money targeting works when the demand for money is stable and predictable. But technological change in the banking system leads to unpredictable changes in the demand for money which makes money targeting unreliable

19

Explain nominal GDP targeting rule

Nominal GDP targeting is a monetary policy rule that adjusts the interest rate to achieve a target growth rate for nominal GDP. The target might be set by the government or adopted by the central bank. Growth rate of nominal GDP equals the growth rate of real GDP plus the inflation rate, as measured by the GDP deflator. The growth rate of real GDP on average keeps returning to the trend growth rate so nominal GDP targeting is a version of inflation targeting. Under this policy the reserve bank would adjust the cash rate when either u flatiron departs from its target or real GDP growth departs from its long term growth rate. Nominal GDP targeting is an old idea that many economists had recommended but it gained momentum during the slow recovery from the last recession.