Aggregate Demand Policies

Question 1

What are the two AD tools?

Answer 1

1. Budgetary Policy (government revenues and expenses) - Smaller changes that have more targeted effects.
2. Monetary Policy (The manipulation of interest rates) - Brutal and big changes that hit everyone at the same time.

Question 2

Effect of AD Tools on the Business Cycle

Answer 2

Both budgetary and monetary policy work (in different ways) to smooth out the level of AD and the business cycle to prevent booms and busts.

Question 3

Why do the RBA and the Government employ MP and BP to avoid troughs and peaks in the business cycle?

Answer 3

During a trough, there’s potential stagflation, lower standards of living, and lower GDP.

During a peak, there’s higher inflation, elevated asset prices, high levels of consumer spending and unsustainable GDP growth.

Thus both are unfavourable for Australia.

Question 4

Role of the RBA with Respect to Monetary Policy.
(The three main goals)

Answer 4

The RBA’s main three goals are:
1. The stability of the currency of Australia
2. The maintenance of full employment in Australia
3. The economic prosperity and well-being of Australians (standards of living)

Question 5

Role of the RBA (in general)

Answer 5

The role of the RBA is to issue monetary policies to smoothen out the business cycle and avoid peaks or troughs, thus stabilising the financial system. The RBA also issues the Australian dollar.

Question 6

What is the Conventional Monetary Policy?

Answer 6

The conventional monetary policy is the cash rate target. The cash rate is the interest rate that banks charge each other for interbank (overnight) loans.

Question 7

Exchange Settlement Account (ESA)

Answer 7

Banks transfer and pay each other via a special account that they each have to hold with the RBA. This account is called an exchange settlement account. (ESA)

When banks borrow/loan money from each other to settle up their outstanding balances at the end of each day, they pay/charge each other a special rate of interest - the cash rate.

(For more info on ESA, check Monetary Policy Slides Part 1: Slide 17-24)

Question 8

How does the cash rate effect the economy?

Answer 8

If banks are borrowing money (at the cash rate, through the ESA), then their costs of business are rising if the cash rate is increasing.

Banks then pass these higher costs on to their customers via an increase in the interest rates on loans that their customers have with them.

This then slows down the economy, aggregate demand and therefore inflation in the economy.

Question 9

What is an Unconventional Monetary Policy

Answer 9

• Unconventional monetary policy tools are used by the RBA in conjunction with conventional monetary policy (cash rate targeting) to help achieve their three macroeconomic goals.
• Unconventional tools are mostly used in extreme situations in an effort to stabilise the business cycle. E.g. during Covid-19

Question 10

Definition of Forward Guidance as an Unconventional MP

Answer 10

Forward Guidance, is an unconventional monetary policy used by the RBA. This involves the RBA providing information about the future course of interest rates and its monetary policy settings.

The RBA publishes for forward guidance through its monetary policy (cash rate) decisions, monetary policy statements, and other media releases.

Question 11

Examples of Forward Guidance and how they work
(the two types)

Answer 11

The RBA identifies 2 different types of forward guidance:

1. State-based: where the RBA commits to a monetary policy setting until certain economic conditions have been met.
   - E.g. ‘the RBA will continue to tighten monetary policy (contractionary) until inflation is within the 2-3% band.’
2. Time-based: where the RBA commits to a monetary policy setting over a specific period of time.
   - E.g. ‘The RBA will keep interest rates low until 2024…’