Monetary policy Flashcards
Monetary policy definition
Monetary policy refers to the action taken by the Reserve Bank to affect the monetary and financial conditions within the economy
Expanding on monetary policy
Is a demand-management tool
Used to fine tune the economy
By making small changes/adjustments in the level of economic activity
To manage the economy and control macroeconomic problems
Pre emptive- acts before happens, to modify the apparent trends
Transparent- economic expectations- anticipating, less of a shock
Objectives of monetary policy
Price stability
Full employment
Economic prosperity/ welfare of Australia
Sustainable economic growth
Inflation targeting
If inflation is contained the other goals of economic growth and full employment should follow
The RBA has adopted a medium term strategy of keeping consumer price inflation between 2-3% on average, over the business cycle
Benefits of low inflation
Maintains the real value of money Protects the value of savings Keeps nominal and real interest rates low Promotes productive investment Reduces uncertainty which promotes long term growth and job creation Promotes international competitiveness Does not distort income distribution Improves decision making
Objective- higher living standards
Higher living standards can be achieved through economic growth which increases employment and raises national income
Transmission mechanism
How changes in interest rates affect the level of economic activity in the economy
Expansionary monetary policy
RBA uses market operations to lower the cash rate- ease monetary policy
This causes changes in other interest rates in the financial system- 90 day bank bill, mortgage rates and personal loans
Exchange settlement accounts (ESA)
All banks in Australia maintain accounts with the RBA to settle interbank transactions. It is through the interaction of demand for and supply of these funds that the cash rate is determined
RBA decreasing the supply of funds
When the RBA wants to decrease the supply of funds it sells Commonwealth government securities to the banks- when the banks pay the funds flow out of the account
Changes in Ç and I impacted on the exchange rate and thus net exports
+ Keynesian model
Interest rate falls can influence the interest rate differential
This may cause a decrease in capital inflow depending on the relative interest rates. Perception of risk may also affect speculative trading in the currency
Decreases the demand for Australian dollars in the forex market- depreciation of the currency
A depreciation of the $A causes exports to be more competitive on the world market while imports become more expensive in Australia currency terms
Net exports are positively affected which adds to the expansionary effect of the changes in consumption and investment
These changes in the components of AE are then multiplies due to the multiplier effect
RBA increasing the supply of funds
When the RBA wants to increase the supply of funds it purchases Commonwealth government securities from the banks- when it pays the banks the funds flow into the account
To ease/lower the cash rate + diagram
Ease-expand the economy Purchases CGS Creates a surplus in ESA Increases liquidity Decreases cash rate
Expansionary monetary policy impact on households
Falling interest rates influence the decisions to save/consume
Decrease the incentive to save as returns on savings deposits in financial institutions fall
Price of credit/borrowing falls stimulating consumption and housing investment
Demand for durable/luxury goods should increase
Disposable income rises due to the decrease payments on existing credit cards/mortgages and loans
Expansionary monetary policy impact on the firms sector + investment demand curve
Interest rates fall
Expansion in the quantity demanded
Cost of borrowed funds fall
Opportunity cost of borrowing falls
Profitability of investment projects affected
Cash flow up due to decrease in interest payments on existing overdrafts/loans
More cash to pay expenses and fund expansion
Response to fall in interest rates is sensitive to the expectations in the economy
Interest rates represent the price of borrowed money. If expectations are very negative the response to the fall in interest regs can be relatively Inelastic
Less than proportionate change in the demand for investment than the change in interest rates- liquidity trap in the most severe situations
Cash rate
Interest rate on overnight interbank loans in the monetary market
RBA manipulates the cash rate through market operations
