Chapter 12: Monetary Policy

Question 1

What is monetary policy?

Answer 1

The actions taken by the RBA to manage interest rates to pursue macroeconomic objectives.

Question 2

What are the goals of monetary policy?

Answer 2

According to the Reserve Bank Act 1959, the goals of monetary policy are:

1. Full employment of the labour force
2. Stability of the Australian currency
3. Economic prosperity and welfare for the people of Australia

Question 3

What is inflation targeting?

Answer 3

Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Question 4

Why is the demand for money downward sloping?

Answer 4

Because money is liquid and you can easily use it to buy goods, services or financial assets (however, it earns either no interest or very low interest).

Question 5

What are the two most important variables (besides interest rates) that cause the money demand curve to shift?

Answer 5

Real GDP and The Price Level.
Financial innovation such as (ATMs), EFTPOS and internet banking have also affected the demand for money, but the above factors have the biggest impact.

Question 6

What is the impact of Real GDP on the demand for money?

Answer 6

An increase in real GDP means that the amount of buying and selling of goods and services will increase. This additional buying and selling increases the demand for money as a medium of exchange; therefore, the quantity of money households and firms want to hold increases at each interest rate = increase in real GDP caused the money demand curve to shift to the right.
A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left.

Question 7

How does the RBA manage the supply of cash?

Answer 7

Through its control of the volume of cash on the overnight money mark. Through this control they can neutralise cash deficits or surpluses to prevent interest rates from changing.
The RBA offsets the daily deficits or surpluses in liquidity through open market operations.

Question 8

What are open market operations?

Answer 8

The RBA purchasing or selling financial instruments such as commonwealth government securities, either by outright purchase or sale, or by the use of repurchase agreements.

Question 9

What is the cash rate?

Answer 9

The interest rate that financial institutions charge on loan or pay to borrow funds in the overnight money market.

Question 10

When does the RBA change interest rates?

Answer 10

Every month the RBA board meets and decides whether to increase or decrease interest rate (through changing he overnight cash rate).

Question 11

What is an exchange settlement account?

Answer 11

Accounts held with the RBA by banks and other financial institutions to enable the overnight transfer of funds (cash) between financial institutions, and between the RBA and financial institutions.
What does the RBA do if they decide to change the cash rate?
It will publicly announce its intention to do so, after which bids and/or offers for financial securities such as repurchase agreements and bonds are then quickly made.
This transparency means that banks and other financial institutions know that the RBA will change liquidity levels in the financial system.

Question 12

How does the RBA reduce the cash rate?

Answer 12

To reduce the cash rate, either the RBA would not sterilise a surplus of overnight funds or it would supply more settlement funds than banks and other financial institutions require by offering to buy back repurchase agreements or make outright purchases of bonds.
As the RBA pays for these financial securities, this increase cash reserves held by financial institutions and subsequently, as the level of liquidity rises, the rate of interest falls.

Question 13

How does the RBA raise the cash rate?

Answer 13

If the RBA decides to raise the cash rate, I will borrow cash from the banks through what are called reverse repurchase agreements, or it could engage in the outright sale of bonds and securities.
This will reduce financial reserves held by financial institutions and subsequently increase interest rates.
Or the RBA may be able to raise interest rates by simply not supplying the necessary liquidity in the case of an overnight shortage of exchange settlement funds.

Question 14

What does the curve representing money supply look like?

Answer 14

The money supply in the economic is horizontal at the current interest rate. This is because the RBA will adjust the availability of overnight funds to whatever level is required to keep interest rates at their targeted level.

Question 15

Explain equilibrium in the money market with interest rate targeting.

Answer 15

Y-axis = interest rate, i
X-axis = quantity of money, M (billions of dollars)
MS curve = money supply curve, straight horizontal line which starts at Y-axis at the current interest rate
MD curve = money demand curve, downward sloping curve
Equilibrium = intersection of MS and MD

Question 16

What is monetary targeting?

Answer 16

Conducting monetary policy to control the size and rate of growth of the money supply. This is no longer used as it is hard to conduct, in turn interest rate targeting is now used.
When using monetary targeting the MS curve is vertical (perfectly inelastic).

Question 17

How do interest rates affects AD?

Answer 17

By affecting C, I, G and NX.

Question 18

How do interest rates affect consumption?

Answer 18

An increase in interest rates increases the returns from lending and the costs of borrowing. A rise in interest rates will create an incentive to cut back on current consumption because it increases the amount of additional future consumption that can be obtained by giving up a unit of current consumption. For households that are net borrowers, this so-called substitution effect will be reinforced by a negative income effect
On the other hand, for households that are net lenders, the outcome of an increase in interest rates is uncertain. The substitution effect will work as before to discourage current consumption, but in this case, there will be a positive income effect. This encourages current and future consumption.
If the substitution is stronger than the income effect, current consumption will still fall and saving will increase. And vice versa.

Question 19

How do interest rates affect consumption?

Answer 19

Firms finance most of their spending on machinery, equipment and factories out of their profits (Retained earnings) or by borrowing. Firms borrow either from the financial markets by issuing corporate bonds, or from banks and other financial institutions. The higher the interest rate, the more expensive it is for firms to borrow.
Therefore, holding other factors constant, a higher real interest rate results in less investment spending and vice versa. (this is the same for households buying new houses and apartments).

Question 20

How do interest rates affect net exports?

Answer 20

The value of net exports depends partly on the exchange rate between the dollar and foreign currencies. When the value of the Australian dollar rises, because Australian commodity export prices are largely traded in US dollars, Australian firms receive less export income.
When the value of the Australian dollar falls, net exports rise. If interest rates in Australia rise relative to interest rates in other countries, investing in Australian financial assets becomes more desirable, causing foreign investors to increase their demand for dollars, which increases the value of the Australian dollar. As the value of the dollar increases, net exports will fall. If interest rates in Australia decliner elative to interest rates in other countries, the value of the dollar will fall and net exports will rise.

Question 21

What is expansionary monetary policy?

Answer 21

The use of monetary policy by the RBA to decrease interest rates to increase real GDP.
EMP causes the AD curve to shift to the right.

Question 22

Explain expansionary monetary policy (EMP): figure 12.7

Answer 22

Y-axis = Price level
X-axis = Real GDP (billions of dollars)
SRAS1 = Upward sloping diagonal line
LRAS1 = straight vertical line
AD1 = Downward sloping diagonal line
A = equilibrium point form intersection between AD1, LRAS1 and SRAS 1

SRAS2 = parallel to SRAS1, but further to right
LRAS2 = parallel to LRAS1, but further to right
AD2(without policy) = in between AD1 and AD(with policy), has fallen short in intersecting with LRAS2
B = intersection between SRAS2 and AD2(without policy)

AD2(with policy) = AD line furthest to right, intersects with SRAS2 and LRAS2
C = intersection between SRAS2, LRAS2 and AD2(with policy)

Without monetary policy, AD will shift from AD1 to AD2(without policy) which is not enough to keep the economy at full employment because LRAS has shifted from LRAS1 to LRAS2. The economy will be in short-run equilibrium at point B.

• By lowering interest rates the RBA can increase I, C and NX sufficiently to shift AD to AD(with policy)
• The economy will be in equilibrium point C, which is its full employment level at LRAS2
• The price level is higher than it would have been if the RBA had not acted to increase spending in the economy.

Question 23

What is contractionary monetary policy?

Answer 23

The use of monetary policy by the RBA to increase interest rates to reduce inflation.

Question 24

Explain contractionary monetary policy (EMP): figure 12.8

Answer 24

Y-axis = Price level
X-axis = Real GDP (billions of dollars)
SRAS1 = Upward sloping diagonal line
LRAS1 = straight vertical line
AD1 = Downward sloping diagonal line
A = equilibrium point form intersection between AD1, LRAS1 and SRAS 1

SRAS2 = parallel to SRAS1, but further to right
LRAS2 = parallel to LRAS1, but further to right
AD2(without policy) = furthest AD line, it a bit further past LRAS2
B = intersection between SRAS2 and AD2(without policy)

AD2(with policy) = AD line in between AD1 and AD2(without policy), intersects with SRAS2 and LRAS2
C = intersection between SRAS2, LRAS2 and AD2(with policy)

Without monetary policy, AD will shift from AD1 to AD2(without policy) which leads to a short-run equilibrium that is greater than potential GDP at LRAS2. The economy will be in short-run equilibrium at point B.

• By increasing interest rates, AD does not increase by as much as it would have without policy.
• The causes the AD2(without policy) curve to shift to the left to AD2(with policy)
• the RBA can increase I, C and NX sufficiently to shift AD to AD2(with policy)
• The economy will be in equilibrium point C, which is its full employment level at LRAS2
• The price level is lower than it would have been if the RBA had not used contractionary monetary policy

Question 25

What is a summary of expansionary monetary policy?

Answer 25

• RBA board decreases the cash rate =
• Other interest rates Fall =
• I, C and NX increase =
• The AD curve shifts to the right by more than it otherwise would have =
• Real GDP and the price level rise by more than they would have without policy.

Question 26

What is a summary of expansionary monetary policy?

Answer 26

• RBA board increases the cash rate =
• Other interest rates rise =
• I, C and NX decrease =
• The AD curve shifts to the right by less than it otherwise would have =
• Real GDP and the price level rise by less than they would have without policy.