Chapter 12 - The nature and operation of monetary policy Flashcards
What is Monetary Policy?
Monetary Policy: is operated by the RBA on behalf of the government and involves the manipulation of key financial variable in the economy (primarily interest rates) in order to achieve specific goals and ultimately improve the living standards or welfare of all Australians
What is the Medium Term Objective?
RBA defines the Medium Term Objective as consumer price inflation between 2 and 3 percent, on average, over the course of a business cycle.
What are the key considerations in regards to monetary policy?
- A focus on low inflation in the medium term to achieve 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
- If low inflation is achieved, then focus on economic growth and full employment in the shorter term, providing this does not jeopardise the goal of low inflation
Monetary policy and Financial Stability
The RBA (indirectly - as APRA is the overwatch of the banks) maintains responsibility for promoting stability of Australia’s financial system by managing liquidity of cash.
The implementation of monetary policy
The RBA implements monetary policy primarily via the manipulation of interest rates, while the RBA has no direct control over interest rates in the economy, its ability to directly manipulate the supply of cash in the overnight money market (cash market) enables it to influence the cash rate which affects all other interest rates in the economy.
How does the RBA manipulate interest rates in regards to the use of ESAs?
The RBA directly manipulates the supply of cash in the cash market via its control over Exchange Settlement Funds (ESAs), which are accounts held by all banks.
- At the end of the day some banks will be in surplus, others in deficits.
- Banks with ESA Surplus, earn a rate of interest from the RBA 25 basis points below the market rate, thus providing banks incentive to minimise surplus.
- Banks with ESA Deficit will be charged a rate of interest by the RBA 25 basis points higher than the market rate, thus providing banks an incentive to fund deficits on the open market
How does the RBA use market forces to manipulate interest rates?
As in any market, the price of cash in the cash market (cash rate) will depend on demand and supply of cash.
- If Injections > Leakages, there is aggregate surplus in ESAs, increasing supply in the cash market and placing downward pressure on the cash rate
- If Injection < Leakages, there will be aggregate deficit in ESAs, decreasing supply in the cash market and placing an upward pressure on the cash rate.
RBA injects cash into the market by buying repos or CGS’s
RBA reduces cash in the market by selling repos or CGS’s
What are Repos?
Repurchase Agreements (Repos): are contracts where the RBA will buy (or sell) a CGS at its current market price but then agree to sell (or buy) the same CGS at an agreed price in the future.
What are CGS’s?
Commonwealth Government Securities (CGSs): exchange-traded Australian government bonds - lowest risk investment as it is backed by the Government and thus the Australian economy.
What is the role of the target Cash rate?
The RBA sets a target cash rate that is consistent with monetary policy settings and the RBA will operate daily in the cash market by performing open market operations (buying & selling repos/CGSs) to ensure the actual cash rate is as close as possible to the target cash rate.
What is a loosening of monetary policy?
A loosening of monetary policy involves the RBA announcing a lower target cash rate , it will the immediately decrease the rate paid (or charged) on surplus (or deficit) ESA balances by the same magnitude. It will then intervene with OMOs to ensure the actual cash rate is close to the target cash rate.
What is a tightening of monetary policy?
A tightening of monetary policy involves the RBA announcing a higher target cash rate, it will then immediately increase the rate paid (or charged) on surplus (or deficit) ESA balances by the same magnitude. It will then intervene with OMOs to ensure the actual cash rate is close to the target cash rate.
How do other interest rates in the economy respond to a change in the cash rate?
It is important to remember that the RBA only has direct control over one interest rate, the cash rate. Accordingly, the extent to which changes in the cash rate flow through to change all other rates depends on the competitiveness pressure existing in financial markets.
What is an expansionary monetary policy stance?
An expansionary monetary policy stance is one where the setting of the target cash rate is low enough to be stimulating AD and economic growth and increasing inflationary pressures.
Monetary policy can become relatively more expansionary without loosening monetary policy. This occurs when the economy is growing strongly but the RBA does not increase the cash rate and can be referred to as a more accommodative stance of monetary policy.
What is a contractionary monetary policy stance?
A contractionary monetary policy stance is also referred to as a restrictive monetary policy stance, where the setting of the target cash rate is high enough to be restricting AD and reducing inflationary pressures.
It is possible for monetary policy to become relatively more restrictive without raising the cash rate by the RBA not changing the cash rate when economic growth is low or declining rapidly and is referred to as a less accommodative stance.
