Monetary policy: action by the RBA, on behalf of the government, to
influence the cost and availability of money and credit in the economy o Used to smooth the effects of fluctuations in the business cycle and influence the level of economic activity, employment and prices The main instrument of monetary policy is domestic market operations (DMO), which indirectly influence the level of interest rates, achieving objectives relating to economic growth, inflation and unemployment o DMO: actions by RBA in the short-term money market (STMM) to buy and sell second-hand Commonwealth Government Securities in order to influence the cash rate and the general level of interest rates o E.g. In short term, tightening monetary policy through upward pressure on interest rates will slow down economic activity through reducing consumption, as consumers face higher mortgage costs. Businesses also usually need to borrow money in order to purchase new capital equipment. Higher interest rates, more expensive to borrow, business investment will decline. This results in lower AD and economic activity o E.g. In short term, loosening monetary policy by reducing interest rates, increase consumer spending and business investment
15.2 Objectives of monetary policy
Monetary policy is the primary macroeconomic policy used to manage the level of economic growth: o Expansionary (loosening): reducing interest rates if growth rises too fast, inflationary pressures will also increase, inconsistent with one of the governments long-term aims o Contractionary (tightening): increasing interest rates reduce inflation, slow down economic growth, increase unemployment RBA aims for: o Stability of $A maintaining low inflation to minimise currency fluctuations o Maintain full employment reducing the level of unemployment o Promote economic prosperity and welfare encouraging sustainable growth 15.3 Inflation targeting Monetary policy is particularly suited to fighting inflation, which is related to monetary factors Interest rate movements can be distorted by political pressures e.g. keeping interest rates low during election
Giving independence to a central bank helps minimise such
political distortions In 1990s, RBA hoped to sustain low inflation and avoid the higher interest rates (and higher unemployment) that may be necessary to reduce high rates of inflation. Also, by targeting inflation, RBA will reduce speculation, hence expectations which would contribute to inflation RBA targets 2-3% of inflation, not putting into account one-off factors e.g. carbon tax, GST. At such times, RBA looks at underlying inflation, instead of headline inflation RBA considers several indicators in its implementation of monetary policy: o Inflation rate o Inflationary expectations o Wages growth o Rate of unemployment o Rate of economic growth o Interest rates o Exchange rate o Commodity prices o Terms of trade o Global economic growth E.g. if wages growth>productivity it can lead to cost-push inflation E.g. depreciation of $A adds inflationary pressures through higher prices for consumer imports and imported inputs to the production process E.g. strong economic growth, reductions in unemployment can add to inflation as economy is approaching its supply capacity (NAIRU) o
15.3 Implementation of monetary policy
Monetary policy involves influencing the cost and availability of
money: o Control of money supply (monetary targeting): currency in the hands of the public and RBA deposits in financial institutions o Influence of interest rates through short-run cash rate (ratesetting monetary policy) Monetary targeting was used during 1970-80s however was not successful as monetary targets were regularly missed and the money supply figures were distorted by the movement of funds from banks to other financial institutions that were not subject to RBA regulation and control Monetary targeting was abandoned mid-1980s. Monetary policy is implemented through interest rate instrument where RBA sets short-run cash rate to influence general level of market interest rates How DMO work Cash rate interest rate paid on overnight loans in the STMM The cash rate is determined by market forces of supply and demand, but RBA can increase or decrease supply of funds in the STMM through DMO thus target the cash rate
RBA influences cash rate by Exchange Settlement Accounts (ESA)
o Banks need to hold a certain proportion of their funds with the RBA in ES accounts in order to settle payments with other banks and RBA DMO: RBA buys or sells securities to a financial institution
15.4 Impact of changes in interest rates
Main effect of a change in interest rates is to change the demand for credit (borrowings) Transmission mechanism: explains how changes in the stance of monetary policy pass through the economy to influence economic objectives such as inflation and economic growth o A fall in the level of interest rates should encourage borrowing by both businesses and consumers, leading to rising consumption and investment demand in the economy, thus increasing the level of spending and raising the level of economic activity o Reducing interest rates also reduces the cost of servicing existing loans, hence leading to additional spending o Fall in interest rates discourages financial inflow leading to a depreciation of $A, making Australian goods more competitive in both domestic and overseas markets. This unintended consequence of a fall in the level of interest rates also has the effect of stimulating AD and economic growth, adding inflation o Increase in AD will also lead to either higher output and employment or will spill over into higher prices and wages if the economy is close to full employment o Increase in aggregate spending that results from lower interest rates, will increase demand for money, , which will be accommodated by RBA raising the supply of money so that (demand = supply) Monetary policy can either be tightened or loosened depending on whether the government wishes to dampen or boost economic activity: o Tightening of monetary policy: DMO increasing interest rates, reducing consumer and investment economic activity, lower economic growth, lower inflation, higher unemployment
Loosening of monetary policy: DMO decrease interest rates,
increasing consumer and investment economic activity, increasing economic growth, falling unemployment, and higher inflationary pressure Although changes in monetary policy can be immediately implemented, monetary policy can have a time lag of somewhere between 6 to 18 months before the full impact of interest rate changes are felt in the economy. For this reason, RBA might be stimulating growth when dampening is required o
15.5 Current stance of monetary policy
Interest rates have varied over time as monetary policy has
responded to varying economic conditions RBA has been successful in controlling inflation averaging 2.7%, aside from the one-off impact of the GST, which pushed inflation to 6% There are 5 main factors that help to explain the stance of monetary policy: o Lower inflation objective: 2-3% of inflation goal o Inflationary expectations: if expected low inflation, prices will plan lower price increases and unions will push for lower wage rises. RBA will increase interest rates to reduce inflationary expectations o Labour costs: because its one of the most significant determinants of inflation o Economic growth and lower unemployment: once RBA believes there is low inflation, it will reduce interest rates to maximise employment. Furthermore, level of growth and unemployment indicate whether economy is close to its supply constraints, where further increase in economic growth will lead to inflation o External factors: when global economic conditions deteriorate, Australia experiences slower economic growth and higher unemployment, and lower interest rates are an important part of the policy response