AOS 4b Flashcards
Goals of the RBA
Goal: Strong and Sustainable Economic Growth
Goal: Full employment
Goal: Low Inflation
Definition of Monetary Policy
Definition of Monetary Policy
A policy operated by the RBA on behalf of the government and involves the manipulation of key financial variables (cash rate target) in order to achieve specific economic goals
Influence Cash Rate Has
Influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation
Inflation Target
Keep Consumer Price Index/Inflation in the economy to 2-3%, on average, over the medium term.
It is this low so that it sufficiently low that it does not materially distort economic decisions in the community
The Impact of A Change In The Cash Rate
Decrease Cash Rate: Stimulates spending and inflation
Increase Cash Rate: Depends spending and inflation
Impact Inflation May Have On Cash Rate
High Inflation: lift the cash rate
Low Inflation: lower the cash rate
Open Market Operations
The RBA can manipulate the supply of cash in the overnight money market to influence the price of cash (the cash rate) which enables them to affect all other interest rates
Policy Interest rate corridor
The RBA operates what is called the policy interest rate corridor within which borrowing and lending by all banks must occur. It is a guidance system and involves the RBA setting a ceiling rate (0.25% above the CRT) and a floor rate (0.10% below the CRT) of interest in the short term money market.
(what are) Exchange Settlement Accounts (ESAs)
Are accounts held by commercial banks with the RBA and are used to facilitate the transfer of funds between between banks. Some accounts will be in surplus, others will be in deficit.
Surplus ESAs
The deposit rate (floor) is the unattractive rate offered to banks with surplus ESA accounts, so it provides an incentive to lend their surpluses to other bank (who have deficit ESA balances) at a higher rate, closer to the cash rate target.
Deficit ESAs
The lending rate (ceiling) is the penalty rate that the RBA charges on deficit ESA balances, so it provides an incentive for banks with deficits in their ESAs to borrow from other banks (with surpluses) at a lower rate closer to the cash rate target.
RBAs Role In Open Market Operations
The demand for cash in their short-term money market can change from day to day.
An increase in the demand for cash by banks will tend to push up the actual cash rate, while a decrease in the demand for cash would cause it to fall.
The RBA will use open market operations on a daily basis to change the supply of cash in the STMM to keep the cash rate on target.
Increased Demand For Cash In the STMM
The RBA would use OMO to repurchase government bonds from banks, increasing liquidity in the STMM and put downward pressure on the cash rate to return it closer to the target rate.
Decreased Demand For Cash In the STMM
The RBA would use OMO to sell government bonds to banks, decreasing liquidity in the STMM and put upward pressure on the cash rate to return it closer to the target rate.
Transmission Mechanisms
The transmission of monetary policy describes how changes made by the Reserve Bank to its monetary policy settings flow through to economic activity and inflation
The Cash Rate
- Is the market interest rate for overnight loans between financial institutions
- A benchmark for interest rates at which funds can be lent or borrowed in financial markets
Interest Rate Pass-through
Is the extent to which changes in the cash rate flow through to other interest rates
Other factors That Influence Interest Rates
- Changes in competition
- Risks associated with different types of loans
The Five Ways Changes In Interest Rates Can Influence Consumption and Investment
- Cost of credit (Savings and investment)
- Cash flow
- Asset price
- Exchange rate
- Availability of credit
Cost of Credit (Savings and investment)
Reduction in interest rates reduces incentives to save and encourages borrowing.
- Households and businesses increase borrowing and spending.
As interest rates fall, the cost of borrowing declines, leading to higher expected returns on
investment projects, this can help to justify going ahead with these projects.
This is known as the ‘inter-temporal substitution’ channel, as households and businesses substitute between spending now and in the future.
Cash Flow Channel
Interest rates influence the spending of households and businesses by changing the amount of interest they pay on debt and the interest they receive on deposits
Cash Flow Channel For Lenders
Lower interest rates on deposits (or other interest-earning assets such as bonds) reduce their interest income; with a lower discretionary income, they may choose to cut their spending
Cash Flow Channel For Borrowers
Lower interest rates can reduce the repayments they must make. This can result in higher discretionary income, and households may choose to spend more
Cash Flow Channel Overview
The cash flow channel is stronger for borrowers. The Australian household sector as a whole is a net debtor. The average borrower holds two to three times as much variable-rate debt as the average lender holds in interest-earning assets.
The spending of borrowers is more sensitive to changes in cash flow than the spending of lenders.
Asset Values/Prices and Wealth Channel
A reduction in interest rates stimulates demand for assets, such housing, raising the prices of these assets.
- An increase in asset prices increases the wealth of households and businesses.
- Can increase the ability to borrow more funds from the bank.
- Can lead to more spending for households and businesses as they generally spend some share of any increase in their wealth.
Impact Interest Rates Have On Exchange Rates
An increase in interest rates will increase the value of the AUD, while decrease in interest rates will depreciate the value of the AUD
Exchange rate channel: Increase Domestic Interest Rates
Will attract foreign funds seeking a higher relative return and will place increase demand on the Australian dollar, driving up the price.
A higher exchange rate will dampen international competitiveness as our exports become relatively more expensive, resulting in lower net exports and decreased economic activity with lower inflation. Imports are also relatively cheaper, further reducing inflationary pressure
Exchange rate channel: Decrease Domestic Interest Rates
Foreign investors seeking a higher relative return elsewhere, decreasing demand for the Australian dollar, lowering the price.
A lower exchange rate will improve international competitiveness as our exports become relatively cheaper, resulting in higher net exports and increased economic activity with upward pressure on inflation. Imports are also relatively more expensive, further increasing inflationary pressure.
Availability of Money and Credit Channel: Interest Rates Increase
Lending criteria will become stricter because the risk of default increases.
Because less households/businesses meet the tighter criteria, the availability of money and credit will fall.
Availability of Money and Credit Channel: Interest Rates Decrease
Lending criteria required will loosen because the risk of default declines.
Because more households/businesses meet the tighter criteria, the availability of money and credit will increase.
Impact of Availability of Money and Credit Channel
With lower access to money/credit, (C) and (I) are likely to fall, reducing AD, economic activity and inflationary pressures.
OR
With more access to money/credit, (C) and (I) are likely to increase, growing AD, economic activity and inflationary pressures.
Monetary Policy Stance: Neutrality
The cash rate is neither working to stimulate or contract the economy.
It will be used when the economy is growing at a strong and sustainable rate with full employment and stability of the currency.
Currently monetary policy neutrality operates at a cash rate of approx 2.5 - 3%, this can change depending on conditions
Monetary Policy Stance: Expansionary
Also referred to as an ‘accommodative stance’, occurs when the cash rate is set below the neutral rate and is low enough to stimulate AD and increase inflationary pressure. Implemented when the economy is growing below trend, inflation is very low and unemployment is relatively high (current economic conditions - hence an extended period with an expansionary stance).
Expansionary policy is anything below 3% cash rate
Loosening of MP = cash rate down, doesn’t mean Expansionary
Monetary Policy Stance: Restrictive/Contractionary
Occurs when the cash rate is set above the neutral rate and is high enough to restrain AD and reduce inflationary pressures.
Contractionary policy is anything above 3% cash rate
Tightening MP = cash rate up, doesn’t mean contractionary
Expansionary or Contractionary
Loosening MP, cash rate up = More expansionary
Tightening MP, cash rate down = More contractionary
Cash rate Below 3% = expansionary
Cash rate above 3% = contractionary
Unchanged = Not neutral, see if above or below 3%
Strengths of Monetary Policy (Evaluate, discuss)
- Free from political bias
- Short implementation lag
- Influence on economic agents (business, individuals)
- Generally strong at restraining AD
Weaknesses of Monetary Policy (Evaluate, discuss)
- Blunt instrument (effects everyone)
- Impact lag (flow on)
- RBA no direct control over interest rates
- Less effective at stimulating AD during a downturn (pay debt instead)
- Cannot directly reduce cost inflation pressures
Employment In Recent Years
- Unemployment peaked at 7.4% in July 2020
- During covid RBA dropped interest rate to a historic low of 0.1% to support jobs and high rates of unemployment
- Historic 50 year low of 3.5% of unemployment in July
- Falling unemployment contributes to the less expansionary MP because high employment results in sustained rates of demand and cost inflation
Inflation In Recent Years
- Inflation has risen to over 6.1% resulting in a tightening in MP
- It was thought that the things causing inflation were short term factors so the CRT was kept low, however it kept rising
Economic Prosperity In Recent Years
- First recession for 20 years in 2020
- WPI has remained low, higher wages lead to demand inflation through consumption and spending, also cost inflation through cost of production
Monetary Policy In Recent Years
- Prior to Covid the RBA maintained an expansionary stance
Factors Affecting MP Over The Past 2 Years
- War in Ukraine (Fuel
- Supply side disruptions (lockdowns)
- Cost of Fuel (cost of production)
- Strong AD (JobKeeper)
- Energy and commodity prices
- Reduced migration (Covid)
- Floods in NSW and Queensland (quality and quantity of resources)
