Ch 12 Monetary

Question 1

Define monetary policy

Answer 1

A policy operated by the RBA on behalf of the government and involves the manipulation of key financial variables in the economy (primarily interest rates) in order to achieve specific economic goals and ultimately improve the living standards or welfare for all Australians

Question 2

Explain the RBAs goal

Answer 2

While better welfare + prosperity (living standards) is the ultimate goal, monetary policy has a clearly defined medium term objective that is seen as the key to the achievement if it’s ultimate goal.
This medium term objective is ‘stability of the Australian currency’ which the RBA currently defined as consumer price inflation between 2-3% on average over the course of the economic cycle
As long as inflation is not sustained above 3% the RBA will achieve other Eco goals

Question 3

Explain the monetary policy objectives

Answer 3

The goal of the monetary policy, requires the RBA board to conduct monetary policy in a way that, in the RBA’s opinion will best contribute to:
The stability in the Australian currency
The maintenance of full employment
The economic prosperity and welfare of the people of Australia

These objectives allow the reserve bank to focus on price (currency) stability, which is crucial factor for long-term economic growth and employment, while taking into account the implications of monetary policy for activity and levels of employment in the short-term.
» “Currency” means prices and it’s principal medium-term objective is to control inflation – NOT the value of the AUD or the exchange rate

The RBAs target for inflation is 2-3% per year over the Eco cycle as long as inflation is not sustained above 3%, the RBA will achieve other Eco goals

Question 4

Explain the RBAs focuses

Answer 4

A focus on achieving low inflation in the medium term which should assist with the achievement of strong economic growth and full employment in the long term
A focus on low inflation should also take into account the impact on growth and employment in the short term (e.g. RBA tightening policy in an effort to reduce inflation if this is likely to push the economy into a recession and increase unemployment to high levels)
If low inflation is achieved, then focus on economic growth and full employment in the shorter term, providing that it does not jeopardise the achievement of it’s low inflation

While the budgetary policy provides support, the monetary policy is the key macroeconomic policy that is used to achieve STABILITY in the level of economic activity (internal stability) where it will greatly be used in a ‘counter-cyclical’ way to boost activity when inflation and growth are low and restrain activity when inflation and growth are high

Question 5

Define underlying rate of inflation

Answer 5

The rate of inflation that provides the best indicators of the predetermined price pressures existing in the economy. Commonly measured to by RBA’s trimmed mean and weighted measures – also referred to as ‘core rate of inflation’

Question 6

Explain the importance of the underlying rate of inflation

Answer 6

The RBA’s target for inflation is clrealy 2-3% headline inflation rate, on average over the course of the economic cycle.
“on average” – means the RBA accepts that there will be short to voliality around the target rate over the economic cycle
This target can only be achieved when deliberating on monetary policy, focuses on a measure of inflation that provides it with an understanding of underlying price pressures existing in the economy
Accordingly it uses the ‘underlying rate of inflation’ as the key statistic that helps it to forecast what is likely to be happening to the headline CPI in the future – in other words the ‘underlying rate of inflation’ is an important tool used by the RBA even through it isn’t the ‘target’

“The reserve bank’s objective is to keep consumer price inflation between 2-3% on average, over the course of the economic cycle. The objective is clearly in terms of the overall CPI. But measures of underling inflation provide information that help to achieve this objective”

Question 7

Explain the implementation of monetary policy

Answer 7

The RBA implements monetary policy via the manipulation of interest rates – while the RBA has no direct control over all interest rates in the economy, it’s ability to directly manipulate the supply of cash in the overnight money market (‘cash market’) enables it to influence the price of cash (cash rate) which then enables it to directly affect all other interest rates

The cash rate is the interest rate that applies to borrowing and lending in the overnight money market. The RBA directly manipulates the supply of cash in the in cash market via it’s control over exchange settlement accounts – which are accounts held by all commercial banks with the RBA. These accounts are set to facilitate the transfer of funds between banks after settling amounts owing following interbank transactions (occurring when cheques + electronic transfers are processed) at the end of each day some banks will have a surplus some will have a deficit

Banks with their ESA’s in surplus earn a rate of interest from the RBA at 25 basis points below the prevailing market rate of interest, which provides them with an incentive to minimize any surplus balances. They will therefore seek to lend (or invest) this surplus cash in the cash market rather than keep the surplus in the ESA earning below interest rates. Similarly ESA’s in deficit will be charged a rate of interest by the RBA at 25 points higher than the prevailing market rate of interest

Question 8

Define exchange settlement accounts

Answer 8

compulsory accounts held by commercial banks with the RBA to facilitate the transfer of funds between banks after settling the amounts owing following interbank transactions

Question 9

Define cash rate

Answer 9

The price of cash in the overnight money market

Question 10

Define cash market

Answer 10

The market for cash or the overnight money market

Question 11

Explain the operations of the monetary policy with banks

Answer 11

Accordingly the banks with surplus funds deposit their cash in the cash market and banks with deficit funds borrow from the cash market.
Given cheques written by the government (such as welfare payments) effectively increase the overall supply of cash in the market referred to as “injections” and cheques written to the government (such as payment of tax-bills) decrease the supply of cash (referred to as leakages) the supply of cash (or ‘liquidity’) is changing on a daily basis
As in any market the price of cash in the cash market will depend on the demand for and the supply of cash. At the end of the day there will either be a shortage or surplus of cash in the cash market

If injections are greater than leakages then there will be an aggregate surplus in ESA’s increasing the supply of funds in the cash market and placing downward pressure on the cash rate
If leakages are greater than injections then there will be an aggregate deficit in ESA’s decreasing the supply of funds in the cash market and placing upward pressure on the cash rate.

Question 12

Define open market operations

Answer 12

the process involved in the manipulation of liquidity market by the RBA via the purchasing and selling of government securities

Question 13

Explain open market operations and the RBA manipulation of the cash rate

Answer 13

If the RBA wanted to do nothing than the cash rate would constantly be changing, the direction and magnitude depending on whether the ESA’s are a surplus or deficit
The RBA manipulates the cash rate by buying + selling commonwealth gov’t securities or repurchase agreements to participate in the cash market (primarily) banks
This manipulation of the cash market is commonly referred to as open market operations or domestic market operations

If liquidity in the cash rate has fallen (market is short of cash) and the RBA wish to prevent a rise in the cash rate then, it would increase liquidity in the market by buying commonwealth government securities or repurchase agreements – this boosts the supply of cash in the market, as the funds are credited to the purchasing banks ESA’s placing downward pressure on the cash rate

Liquidity increases in the market because cash market participants will have higher ESA’s balances (in exchange for CGS or repos sold to the RBA) which they immediately release into the market (because they ESA’s earn below market interest rate) This increases the supply of cash in the market forcing down the cash rate

If liquidity has increased (greater supply of cash in the market) and the RBA wished to prevent a fall in the cash rate, it would decrease ‘liquidity’ in the market by selling CGS or Repos. This places upward pressure on the cash rate. Note that liquidty decreases in the market because cash market percipients received CGS or Repos in exchange for cash.
This manipulation of liquidity in the cash market by the RBA is referred to as either “open market operations” or “domestic market operations”

Question 14

Explain the role of the target cash rate

Answer 14

The RBA sets a target cash rate that is consistent with monetary policy settings as determined at the RBA’s monthly board meetings.
Once the target is set, the RBA will operate in the cash market on a daily basis via OMO’s to ensure that the actual cash rate is close as possible to the target cash rate
The actual cash rate will always be hovering very close to the target and at 9:30 am every morning the RBA will determine whether it needs to increase liquidity (if the actual cash rate is above the target) or decrease liquidity (if the actual cash rate is below the target)

Question 15

Explain a loosening monetary policy

Answer 15

A “loosening” monetary policy involves the RBA announcing a ‘lower target cash rate’ in it’s monthly board meetings
e.g. deciding 2.75% to 2.50% it will immediately decrease the rate paid (or charged) on surplus (or deficit) ESA balances by the same magnitude.
For example – the rate paid on ESA surplus balances would fall from 2.50% to 2.25% (since as noted above the rate paid on ESA surpluses balances is always 25 basis points below the target cash rate) it will then intervene in the market via OMO’s to ensure that at the start of each day, the actual cash rate is as close as possible to the new lower target cash rate. Theoretically this will involve the RBA acting swiftly to increase liquidity (via buying of CGS or Repos) in order to decrease the cash rate towards the new lower target

However in reality the market will automatically adjust without this RBA intervention because the mere ‘expectation’ that the RBA will act to reduce the cash rate to it’s new target is enough for this to happen immediately – accordingly following a loosening of monetary policy, the RBA will simply need to focus once more on narrowing or eliminating the hap between the actual cash rate and the new target cash rate

Question 16

Explain a tightening monetary policy

Answer 16

“tightening” of monetary policy involves the RBA announcing a higher target cash rate at one of it’s monthly board meetings e.g. from 2.50% to 2.75% it will then intervene in the market via OMO’s to decrease liquidity (by selling CGS or repos) and drive the actual cash rate up towards it’s new target. Thereafter the RBA will ensure that, at the start of each day, the actual cash rate is as close as possible to the new higher target cash rate

Question 17

To raise interest rates:

Answer 17

Increase cash target rate set by RBA
RBA can decrease liquidity in the cash market by selling CGS/repos at a cheaper price that would be more attractive to banks
This takes money out of banks ESA’s and the cash market
A shortagere will place upward pressure on the cash rate (the interest rate in the omm)

Question 18

To decrease interest rates the RBA will:

Answer 18

Decrease the cash rate target set by the RBA
The RBA can increase liquidity in the cash market by buying CGS/repos at a higher price so banks would be willing to sell this increases the supply in the money market and places downward pressure on the cash market

Question 19

How does the cash rate effect broader interest rates?

Answer 19

Eg term deposits, home loans, credit cards Will be shifted in accordance (relatively) with the cash rate otherwise people wouldn’t invest in certain products
In order to retain market share - competition of funds can cause other rates to increase in line with the increase in the cash rate
Not always true as some banks do not pass on interest rates cuts

Question 20

Explain an expansionary monetary policy

Answer 20

An expansionary monetary policy stance is one where the setting of the target cash rate is low enough to be stimulating AD and increasing inflationary pressure.
While the RBA does not publish information about how the level of cash needs to fall before the monetary policy becomes expansionary, it can be argued that in 2014-15 the cash rate needs to fall below approx. 3.50%. This rate by no means is fixed and has fallen over recent years owing to changed in the relationship between the cash rate and general interest rates.
E.g. 2006-7 the cash rate needed to fall below 5.5% before monetary policy was considered expansionary

Question 21

How can the monetary policy become more expansionary without any changes - loosening the policy?

Answer 21

is possible for the monetaur policy to become relatively more expansionary even without loosening of policy. This can occur if the economy is growing strongly, or indeed overheating, and the RBA does not change the cash rate – This sceniiro is referred to as a more ‘accomodative stance’ of monetary policy. Similarly is is possible for the monetary policy to be expansionary, even through the RBA is tightening monetary policy
e.g. tightening the monetary policy from 3% to 4.25% did not alter the fact that the monetary policy stance during this period was expansionary – in other words even through the interest rate were increasing, they were still low enough to stimulate economic activity

Question 22

Explain a contractionary monetary policy stance

Answer 22

contractionary monetary policy stance is also referred to as ‘restrictive’ monetary policy. I is one where the setting of the target cash rate is high enough to be restraining AD as reducing inflationary pressure. It currently occurs when the target cash rate is above approx. 3.50%
However it is also possible for the monetary policy to become relatively more restrictive even without tightening of policy. This can occur is eco growth is low or declining rapidly and the RBA does not change the cash rate – this scenario is sometimes referred to as a less accommodative stance of monetary policy. Similarly is it possible for the monetary policy stance to be restrictive, even when the RBA is loosening monetary policy

Question 23

Explain a ‘monetary policy neutrality’ stance

Answer 23

If the monetary policy is neither expansionary nor restrictive then the cash rate is considered to be the ‘normal’ rate, commonly referred to as ‘monetary policy neutrality’ This describes a situation where the level of cash rate is neither working to stimulate nor contract the economy. That is monetary policy is neither having an expansionary nor contractionary effect on the economy and it is sometimes referred to as the target cash rate that exists when the economy is growing at it’s trend rate of growth (approx. 3%) and inflation is under control.
Currently monetary policy neutrality arguably occurs when the target cash rate is about 3.5%. Accordingly if the economy is growing at a ‘healthy or sustainable rate’, then the target cash rate is likely to be approx. 3.5% A rate higher than 3.5% suggests that the economy is growing at an excessive rate of inflationary and inflationary pressures are too high. A lower rate than 3.5% suggest that the economy is growing slowly and inflationary pressures are negligible.

Question 24

Define monetary policy neutrality

Answer 24

When monetary policy is neither in an expansionary or restrictive phase - the level for the target cash rate is neither expanding nor restricting Eco activity
Currently 3.5%

Question 25

Define accommodative monetary policy

Answer 25

When the RBA leaves the target cash rate unchanged during times of strong Eco growth

Question 26

Define transition mechanism

Answer 26

The way a change in interest rates affects Eco activity - there are generally 5 recognised transmission mechanisms (channels)

Question 27

What are the 5 transmission channels / mechanisms

Answer 27

The transmission mechanism refers to the way a change in interest rates affects economic activity. In reality there are 5 ways that interest rates changes ‘transmit’ their effects on economic activity – the transmission occurs via 5 separate channels:
The cost of credit (savings + investment)
Cash flows
Availability of money
Asset values/prices
Exchange rate

Question 28

Explain the cost of credit channel

Answer 28

A tighter monetary policy will result in higher interest rates which make it more costly to borrow money. This higher cost of credit should reduce the willingness of households to borrow money for the purchase of goods + services, and provide them with a greater incentive to save. In particular it reduces the demand for consumer durables, and overall it is likely to reduce consumption demand in the economy.
Similarly, businesses are likely to reduce or delay investment as higher borrowing costs makes any investment spending less viable. This is because it become more difficult for any investment project to achieve the ‘hurdle rate of return’ that is necessary for approval. The consequent reduction in consumption and investment works to reduce AD and eco growth

Question 29

Explain the cash flow channel

Answer 29

Higher interest rate negatively impact on those in the economy with existing variable rate loans, in particular, households with mortgages will immediately suffer a drop in their ‘cash flow’ (or discretionary income) as more of their disposable income needs to be used to repay the interest component of their mortgage, accordingly households will, in aggregate reduce consumption and AD in the economy.
Similarly the business sector will experience a drop in cash flow as they spend more to service any variable rate loans, further reducing AD via investment
More household cash available (discretionary incomes) as lower repayments on existing loans increases C + I

Question 30

Explain the availability of credit channel

Answer 30

The availability of money is likely to fall in time of higher interest rates because it makes it less likely that some households or businesses will meet the lending criteria established by financial intuitions because the risk od default increases. This is because borrowers must service higher interest rate repayments, which makes it more probable that they will struggle to service the loan, increasing the ‘risk’ of non-repayment. In short banks are more likely to reduce the number of loan approvals to both household + business sector when interest rates rise

If interest rates are down banks may be more flexible to give loans increasing c + I

Question 31

Explain the asset values/prices channel

Answer 31

With higher interest rates asset value + prices are likely to fall because the demand for various types of assets (houses, shares, gold) should be lower.
This reduces ‘wealth’, consumption, AD and eco activity. It is fair to expect a decline in the rate of spending by these asset owners as they experience a decline in their wealth. Some will experience a drop in their real wealth if they sell their assets at a lower price than the purchase price

Interest rates down = people have more credit on hand - more willing to spend on assets

Question 32

Explain the exchange rate channel

Answer 32

The exchange rate will generally be positively correlated to interest rates, such as that a rise in interest rate is expected to cause an appreciation of the AUD – this is because higher domestic interest rates attract foreing funds (capital inflow) seeking relatively higher rates of return on their investments.
As foreing funds enter, they are exchanged into Australian dollars, increasing the demand for the AUD thereby exertin upward pressure on the value of the AUD. A higher exchange rate reduced international competiveness, reducing net exports (x-m) and decreasing economic activity and inflationary pressure, additionally high exchange rate makes imports relatively cheaper and reduces the price of imported consumer and producer goods. This further reduces inflationary pressure in the economy.

Question 33

Explain exchange rate intervention

Answer 33

Interest rates will impact on the value of the AUD via international capital (money) flows, but the RBA will not specifically tighten or loosen monetary policy in an effort to increase or decrease the exchange rate.
Unlike inflation the RBA does not target a particular level for the value of the dollar. However it will occasionally intervene in the foreign exchange market if it believes that the Australian dollar has clearly overshot or undershot it’s fundamental or underlying value
E.g. if AUD was rising too much, pushed along by speculation, then the RBA may decide to reduce pressure on it’s value via manipulation in the foreign exchange market, similarly the RBA may intervene to smooth out ‘persistent volatility’ in the exchange rate
To manipulate the AUD the RBA directly enters the foreign exchange market and either buys or sells Australian dollars in exchange fir another currency (typically USD). When it purchases (demands) the AUD, it places upward pressure on it’s value and when it sells (supplies) the dollar it places downward pressure on it’s value. However given that domestic banks operate in foreign exchange markets via their purchases and sales of foreign currency, any RBA intervention has implications for liquidity in the cash market and monetary policy more generally
The RBA’S manipulation of the exchange rate is sometimes referred to as a “dirty float”

Rising interest rates relative to overseas will see an increase in capital inflow increasing the demand for the $aud and er

Question 34

Define dirty float

Answer 34

The RBAs manipulation of the exchange rate via buying and selling of Aud in the foreign exchange market

Question 35

Define sterilised intervention

Answer 35

When the RBA totally offsets the impact on liquidity in the cash market following any intervention in the foreign exchange market

Question 36

Explain sterilised intervention

Answer 36

If the RBA seeks to increase the value of the AUD, it purchases Aus dollars from domestic banks with it’s stock of foreign currency. This ultimately draws funds out of the cash market, reducing liquidity and placing upward pressure on the cash rate, moving it above the target cash rate. If the RBA were to allow the cash rate to remain above the target it is effective it the same as tightening monetary policy. To prevent this from happening, the RBA must restore liquidity in the cash market via open market operations (in this case purchasing securities). When the RBA totally offsets the impact of liquidity in the cash market it is referred to as ‘sterilized intervention’
Conversely if the RBA sought to prevent the dollar from rising too much it would purchase foreign currency (sell aus dollars) driving up the price of foreign currency and reducing the value of the AUD. This would work to increase liquidity in the cash market and would force the cash rate below the target cash rate. To ‘sterilize’ this intervention the RBA must reduce liquidity back to it’s former level by selling securities

Question 37

Explain some lags associated with the monetary policy

Answer 37

Recognition - key economic figures are not live or up to date when decisions are made

Implementation - have to wait monthly to implement changes

Transformation - how long it takes to have an impact within the economy e.g through c+I can be 18 months to 2 years

Question 38

Achieving low inflation

Answer 38

Employ a contractionary monetary policy (raising interest rates) in order to slow the levels of Ad - the tightenings of interest rates will reduce c+I
Mention channels *

Question 39

Using monetary policy to stimulate ad

Answer 39

Monetary policy is used in a counter cyclical fashion
Decrease interest rates in order to increase ad in times of slow GDP growth
C + I = ad ^ = GDP ^

But the RBA states that low inflation is a PRE CONDITION in order to achieve its growth and employment goals because:
Low inflation leads to greater purchasing power - leading to increase to C
Low inflation positively affects international competivness which will increase X

Question 40

How monetary policy achieving employment goal

Answer 40

interest rates down c up ad up derived demand for labour up

Question 41

Define progressive tax

Answer 41

Tax the collects proportionally more from higher income earners compared to low income earners involves the rate of tax increasing as income increases

Question 42

Define proportional tax

Answer 42

Tax that collects proportionally identical amounts from all income earners - it involves the rate of tax remaining the same for all tax payers - e.g company tax

Question 43

Define regressive tax

Answer 43

Tax that collects proportionally more lower income earners compared to higher income earners - involves the rate of tax decreasing as incomes increases