Monetary Policy

Question 1

What is monetary policy?

Answer 1

Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’)

Question 2

What is the rationale for monetary policy?

Answer 2

To change interest rates in the economy in order to shift aggregate demand and stabilise the business cycle

Question 3

How does monetary policy control inflation?

Answer 3

1) It shifts AD to increase/decrease demand inflation
2) It anchors inflationary expectations – individuals and firms now assume inflation will be 2-3% because they know the RBA will try to ensure that it is

Question 4

The process by which a change in the cash rate flows through to a change in aggregate demand is called…

Answer 4

The transmission mechanism

Question 5

What are the 4 transmission channels?

Answer 5

1) Increased saving and decreased borrowing (for consumption and investment)
2) Decreased demand for assets, so asset owners feel less wealthy (lowering consumer confidence)
3) Increased interest costs for mortgage-holders, so people have less funds available for consumption
4) Appreciation of the AUD, so imports rise and exports fall

Question 6

The RBA raises the cash rate. Is this expansionary or contractionary?

Answer 6

Contractionary

Question 7

The RBA lowers the cash rate. Is this expansionary or contractionary?

Answer 7

Expansionary

Question 8

The RBA buys second-hand Commonwealth Government Securities as part of its Open Market Operations. Will the cash rate increase or decrease?

Answer 8

Expansionary

Question 9

The RBA sells second-hand Commonwealth Government Securities as part of its Open Market Operations. Will the cash rate increase or decrease?

Answer 9

Contractionary

Question 10

How will an increase in the cash rate affect the value of the Australian dollar?

Answer 10

Foreigners will be more willing to lend to Australians (increasing demand for the AUD) and Australians will be less willing to lend to foreigners (decreasing supply), so the AUD will appreciate

Question 11

What was the RBA’s monetary policy during the 2010s?

Answer 11

Expansionary: A low cash rate around 1.5%, but this was counteracted by a contractionary fiscal policy

Question 12

What are the limitations of using expansionary monetary policy to increase economic growth?

Answer 12

1) Time lags

2) Global influences:
Impact on exchange rate depends on other countries’ monetary policy

3) Liquidity trap (becomes less effective as interest rates approach 0%)

4) Can create asset bubbles (e.g. housing bubble) or financial instability (e.g. Silicon Valley Bank)

5) Is a ‘blunt’ tool - cannot address structural issues (i.e. capacity constraints) or cost inflation

6) Has the opposite effect on cost inflation (due to change in interest costs for firms)

Question 13

What are the time lags for the use of monetary policy?

Answer 13

It can be implemented immediately by the RBA, but takes around 12 months for changes in the cash rate to flow through to changes in AD because it takes time for individuals and firms to change their borrowing and spending behaviour

Question 14

What was the RBA’s monetary policy during the pandemic?

Answer 14

Expansionary: Dropped the cash rate from 1.5% to 0.1%, and also introduced ‘unconventional monetary policy’ such as the Term Funding Facility and quantitative easing

Question 15

What has the RBA’s monetary policy been since the pandemic?

Answer 15

Contractionary, but done too late: Raised the cash rate consistently since May 2022, from 0.1% to 4.1% in 2023

Question 16

How does the RBA change the cash rate?

Answer 16

1) Buying and selling second-hand Commonwealth Government Securities as part of its Open Market Operations
2) Raising or lowering the ‘price corridor’ at which firms can lend to each other between their Exchange Settlement Accounts

Question 17

Why does buying/selling second-hand Commonwealth Government Securities change the cash rate?

Answer 17

If the RBA buys CGOs from banks, it pays into those banks’ Exchange Settlement Accounts.

Banks then have a greater supply of funds with which to lend to other banks.

This increases the supply of funds, decreasing the interest rate charged on those loans.

The opposite is true if the RBA sells CGOs.

Question 18

How does the RBA use a cash rate corridor to change the cash rate?

Answer 18

It sets a maximum and minimum interest rate at which banks will lend to each other between their Exchange Settlement Accounts. This ensures the actual cash rate will settle somewhere between the two.

It sets the maximum by offering to lend to banks at 0.25% above the target cash rate (so banks would never borrow from another bank for more than that), and it sets a minimum by paying interest on funds left in a bank’s account at 0.1% below the target cash rate (so banks would never lend out their money for less than that)

Question 19

Why does a change in the cash rate lead to a change in other interest rates in the economy?

Answer 19

A higher cash rate increases the cost to banks of borrowing funds, so they pass on those higher costs to customers in the form of higher interest rates on other loans

Question 20

In the pandemic, the RBA also did ‘unconventional monetary policy’ for the first time. What did this involve?

Answer 20

1) $190 billion Term Funding Facility

2) $281 billion of quantitative easing

Question 21

What is the Term Funding Facility?

Answer 21

The RBA printed money to lend to banks at low interest rates as long as it was lent to firms.

Question 22

How did the Term Funding Facility help to stabilise inflation?

Answer 22

In the pandemic, firms lacked the cash flow to continue paying wages and bills, so they needed to borrow money but banks thought it was risky to lend to them.

The TFF increased how much banks were able and willing to lend to firms, to allow them to borrow at a lower interest rate.

This helped ensure bills and wages were paid and firms continued to operate, supporting incomes, aggregate demand and demand inflation

Question 23

How did the Term Funding Facility help to stabilise inflation?

Answer 23

The TFF increased how much banks were able and willing to lend to firms, to allow firms to borrow at a lower interest rate.

This helped ensure bills and wages were paid and firms continued to operate, supporting incomes, aggregate demand and demand inflation

Question 24

What is quantitative easing?

Answer 24

The RBA prints money to buy second-hand Government bonds, which reduces the interest yield earned on buying bonds (lending to the government).

Due to the lower interest rate available on lending to the government, banks are now willing to lend to firms at a lower interest rate than before as well.

Question 25

How did quantitative easing help to stabilise inflation?

Answer 25

QE lowered the interest rates charged to firms. As a result, firms found it cheaper borrow for investment, increasing AD and demand inflation