Monetary Policy

Question 1

What is a monetary policy

Answer 1

• the RBA’s channel of stabilisation which manipulates the availability and cost of money and credit through interest/cash rates
• influences AD

Question 2

What is macroeconomic stabilisation

Answer 2

• function of the gvrnment and the RBA to influence internal stability, external stability, and sustainable EG
• aims to minimise the natural volatility of the market

Question 3

What are the three monetary polic stances and what does each one mean?

Answer 3

Contractionary:
- raising interest rates such that AD is reduced in the eoconomy
Expansionary:
- lowers interest rates to stimulate economic activity and increase AD
Neutral:
- a stable interest rate is maintained to ensure that AD is maintained stabiliy

Question 4

What is are the objectives of Monetary Policy as outlined in its charter

Answer 4

The stability of the currency:
- low inflation - 2-3%
- exchange rate stability

Low unemployment:
- 4-5%

Economic prosperity and welfare of people
- GDP growth

Question 5

What is the role of the RBA

Answer 5

To change interest rates/cash rates to affect cost, supply/demand of credity and the rate at which credit flows between financial sectors and the rest of the economy

Question 6

What is the concept of inflation targetting

Answer 6

• the RBA’s strategy of specifying an inflation rate as a goal and adjusting monetary policy to achieve that rate
• the RBA’s current goal is 2-3% inflation

Question 7

Expansionary Stance

Answer 7

• the RBA buys Commonwealth Gvrnment securities (CGS), releasing extra cash into the ESA’s
• this creates a surplus of cash –> places downwards pressure on the cash rate as banks would rather keep because of higher market interest rates
• lower cash rate encourages borrowing + spending

Question 8

Contractionary stance

Answer 8

• the RBA sells CGS, reducing the cash in ESA’s
• this creates a deficit of cash –> palces upward pressure on the cash with banks borrowing to keep ESA’s in surplus as required
• higher cash rate discourages borrowing + spending

Question 9

What are CGS and ESA’s

Answer 9

CGS:
- bonds issued by the commonwealth of Australia

ESA’s:
- exchange settlement account is the bank account that banks use to settle transactions between themselves

Question 10

What are the four transmission mechanisms?

Answer 10

1. Savings and investment channel
2. Cash-flow channel
3. Asset prices and wealth channel
4. Exchange rate channel

Question 11

Describe the savings and investment channel

Answer 11

• lower interest rates will encourage spending and borrowing but will discourage saving
• this makes it expansionary
• higher interest rates are contractionary

Question 12

Describe the cash-flow channel

Answer 12

It influences the spending decisions of households / businesses by reducing the amount of interest they pay on debt and the interest they receive on deposits
this affects their disposable income or “cash flow”

Question 13

The effect of lower interest rates on borrowers in the CF channel

Answer 13

• reduce the interest payments and mortgage rates
• results in a higher disposable income –> spending increases

Question 14

The effect of lower interest rates on lenders in the CF channel

Answer 14

• they face lower deposit rates, reducing their interest income
• this reduces their disposable income –> decreases spending

Question 15

Describe the asset prices and wealth channel

Answer 15

• lower interest ratres lead to lower lending rates, higher house prices and increased spending - expansionary
• higher interest rates is contractionary

Question 16

Describe the exhange rate channel

Answer 16

Interest rates influence the exchange rate, influencing the exports/imports sector of AD

Question 17

The effect of lowering interest rates on the ER channel

Answer 17

Interest rates decrease
Exchange rate depreciates:
- export prices decrease to foregin buyers / export volumes increase
- import prices increase to domestic buyers / import volume decreases

Economic activity increases –> inflation increases and unemployment decreases –> expansionary

Question 18

What are the two limitations of monetary policy?

Answer 18

• indirect transmission mechanism
• time lags

Question 19

What is the problem with indirect transmission mechanisms?

Answer 19

• in certain situations, changes in interest rates will not influence consumer behaviour to increase expenditure/borrowing
• e.g in a recession as consumers are unsure about the economic future

Question 20

What is the problem with time lags?

Answer 20

• with long outside time lag, the time taken for the cash rate to affect interest rate and economic activity
• there are a lot of steps that needs to be complete for the final effect of changing CRs to occur

Question 21

What are the three strengths of monetary policy?

Answer 21

• freedom from political constraints
• short inside time lag
• inflationary expectations