U4AOS1 - Monetary Policy

Question 1

Monetary policy

Answer 1

Monetary policy is an Aggregate Demand side policy where the RBA manipulates the cash rate in order to regulate economic activity and improve living standards

The three objectives of monetary policy are stability of currency, maintenance of full employment; and economic prosperity and welfare of people in Australia

Question 2

The role of the RBA with respect to monetary policy

Answer 2

3 objectives of the charter:

• Stability of the currency (goal of price stability)
• Maintenance of full employment (goal of full employment)
• Economic prosperity and welfare of people in Australia (living standards and goal of strong and sustainable economic growth)

Cash rate:
The interest rate applied to borrowing / lending in the overnight money market. It is the tool used to implement monetary policy.

Cash rate target:
The cash rate target is set by the RBA and is a benchmark for other interest rates. It is the main way monetary policy is implemented.

Cash market:
The market for overnight loans between banks.

Question 3

Transmission mechanisms - Cost of credit (savings and investment channel)

Answer 3

The way this transmission mechanism works is as when costs to borrow fall, both firms and individuals are incentivised to borrow more, boosting C (private consumption expenditure) and I (private investment expenditure) and therefore Aggregate Demand and economic growth as well.

When there is high household indebtedness the cost of credit or savings and investment channel may not be as effective as even with low interests some households will remain unwilling to borrow more.

Question 4

Transmission mechanisms - Cash flows

Answer 4

The way this transmission mechanism works is when interest rates are low, those with already existing loans – in particular individuals with mortgages on their homes – will have to pay less, which increases cash flows / their discretionary income.

The increase in cash flows means that C (private consumption expenditure) should rise, boosting AD and economic growth.

Will also impact businesses with loans through I (private investment expenditure).

Question 5

Transmission mechanisms - Availability of money and credit

Answer 5

In times of lower interest rates (expansionary monetary policy) financial institutions are far more likely to approve loans, as it is far less risky.

This works to boost C (private consumption expenditure) and I (private investment expenditure), helping to improve Aggregate Demand and economic growth.

Question 6

Transmission mechanisms - Asset value and wealth

Answer 6

As the cost of borrowing decreases due to lowered interest rates, demand for assets like property increases.

This increased demand increases the value of people’s assets / wealth as well as the C component (private consumption expenditure) of aggregate demand.

This will also boost aggregate demand as a whole and economic activity

Question 7

Transmission mechanisms - Exchange rates

Answer 7

With expansionary monetary policy and lowered interest rates, people are disincentivised to invest in Australian banks, leading to a reduction in demand for AUD.

This causes a depreciation of the Australian dollar, leading to an increase in demand for Australian exports as they become relatively cheaper for others to purchase and a decrease of imports as they become relatively dearer for Australians to purchase.

This causes a boost in aggregate demand and economic growth.

Question 8

Stance of monetary policy

Answer 8

The stance of monetary policy refers to whether it aims to boost or contract the economy

Expansionary monetary policy stance
When the RBA lowers the cash rate target, Aims to boost economic activity

Contractionary monetary policy stance:
When the RBA increases the cash rate target. Aims to contract economic activity. Cash rate target of 3%+ is considered contractionary

Question 9

strengths of using monetary policy to achieve the Australian Government’s domestic macroeconomic goals and how these goals may affect living standards.

Answer 9

• RBA has meetings every month (apart from January) meaning it is a relatively flexible policy (unlike budgetary policy) as there is opportunities to re-evaluate and change the cash rate target on a monthly basis. The implementation lag for monetary policy is very short.
• RBA (unlike budgetary policy) makes decisions free from political bias.
• Monetary policy has powerful influence on the expectations of economic agents. This is because the words of the RBA governor are closely followed.
• Is a very powerful tool when contracting the economy. Unfortunately, over the past two years the economy has only needed expanding, which monetary policy does not do as well.

Question 10

Weaknesses of using monetary policy to achieve the Australian Government’s domestic macroeconomic goals and how these goals may affect living standards.

Answer 10

It is a blunt instrument, meaning it is unable to target specific industries. This contrasts to budgetary policy, which can offer assistance to certain specific industries.

Less effective at stimulating Aggregate Demand, particularly in instances of high household indebtedness. Despite very low interest rates, households with high levels of debt may still not borrow, meaning that the cost of credit / savings and investments channel is not working as intended.

Despite monetary policy’s short implementation lag, it has a very long impact lag and can take over a year before monetary policy has any significant impact on economic activity.

Question 11

Open market operation (OMO):

Answer 11

Activity performed by the RBA to change the level of liquidity in its currency.

This activity is performed by regulating the supply of cash by buying and selling financial instruments such as Commonwealth Government Securities

Question 12

Exchange Settlement Account

Answer 12

Account that all banks must have and are used to settle all interbank transactions

The balance is required to always be positive

RBA estimates the demand for ES every day.

Question 13

RBA’s role as banker to the banks

Answer 13

• All banks are required to keep ESA with RBA
• Banks must ensure ESAs have a positive balance
• ESA main purpose is to allow settlement of debts between banks, which occur due to the movement of cheques / EFTPOS between customers of different banks
• RBA makes use of ESA to set the cash rate through market conditions
• RBA can alter cash rate by buying and selling government bonds / securities
• It can do this as RBA has monopoly on supply of funds
• When RBA wants to increase cash rate it will sell bonds to banks, reducing liquidity in the money market, forcing interest rates to rise. Vice versa for decreasing the cash rate.

Question 14

Policy interest rate corridor:

Answer 14

Floor and a ceiling around the cash rate target in the Australian cash market

The floor is the RBA deposit rate, and the ceiling is the RBA lending rate and as there is no incentive to borrow at interest rates higher than the ceiling and lower than the floor all market activity is contained within the corridor.

Range that the actual cash rate can be.

Question 15

RBA lending rate

Answer 15

RBA lending rate is the rate to lend money that the RBA offers

Acts as a cash rate ceiling as banks have zero incentive to borrow money at a higher interest rate

RBA lending rate is set at 0.25% higher than cash rate target

Question 16

RBA deposit rate:

Answer 16

RBA deposit rate is the rate to accept deposits that the RBA offers

Acts as a cash rate floor because banks have zero incentive to accept a deposit rate lower than the one the RBA offers

RBA lending rate normally sits at 0.25% below the cash rate target, but as the cash rate target is currently so low, it now sits 0.1% lower than the cash rate target