Monetary Policy Flashcards
1
Q
Monetary policy
A
Refers to those actions taken by RBA to affect monetary and financial conditions in the economy by affecting the price of money and credit.
- Aims to achieve low inflation (price stability) and sustainable economic growth
- indirectly affect interest rates throughout the economy by setting the interest rate on overnight loans in the money market
2
Q
the cash rate
A
- rate on overnight loans in the money market
3
Q
- Interest rates
A
- represent the cost or price of money and credit
- Changes in interest rates affect level of spending and demand in the economy
- Interest rates influence private sector’s decisions regarding consumption, saving and investment
- Changes in interest rates also affect exchange rate
- Small changes in interest rates can have a powerful effect on AD which then affects the level of output, employment and prices
4
Q
The financial sector
A
- Monetary policy works through financial markets
- Financial markets channel funds from savers to investors to finance investment and spending in the economy
- Primary role is to act as an intermediary between saves and investors or borrowers and lenders of funds
5
Q
An Increase in Real interest Rates
A
- Increase demand for loanable funds:
- Increase in economic activity
- > If business confidence grows and profit expectations increase, then firms will increase their demand for funds to finance increased investment
- > When employment and incomes are high, households are likely to increase their demand for housing which will also boost the demand for loanable funds
- > An increase in demand for funds by the private sector will increase real interest rates and the quantity of funds invested
- A government budget deficit
- > Occurs when G’s planned spending exceeds its revenue
- > G must borrow to meet the shortfall and this will increase the demand for funds and raise interest rates
- > This will have negative effect on private investment
- > Private investment decreases and is said to be ‘crowded out’ by the increase in G spending
- Decrease supply of loanable funds:
- Decrease in private saving
- > If firms and/or households decrease their saving, real interest rates increases and quantity of funds invested lowers
- > Fall in economic activity will lead to a fall in the profits of firms and an increase in unemployment
- > Lower real incomes will decrease the overall level of saving in the economy and raise interest rates
6
Q
A decrease in real interest rates
A
- Demand for loanable funds decrease
- Supply of loanable funds increase
Factors decrease demand for loanable funds:
- Decrease in economic activity
- > If economy contracts and production and employment levels fall, then investment by firms will decrease which will reduce the demand for loanable funds
- > Low economic activity, households will decrease their demand for housing and durable goods such as motor goods, thus decreasing real interest rates
Factors Increase supply of loanable funds:
-A government budget surplus
-> Occurs when G’s planned revenue exceeds its spending
-> G is effectively saving and this will increase the supply of funds and decrease the real interest rate
-> This will have a positive effect on private investment
> Private investment increases and is said to be ‘crowded in’ by the increase in G saving
- Increase in private saving
- > Increase in household income will normally increase saving
- > An increase in business profits may lead to an increase in corporate saving
7
Q
Monetary Policy
A
- RBA’s main monetary policy instrument is the overnight cash rate in the short term money market
- > Influenced by the bank’s buying and selling of Commonwealth government securities
- Monetary policy can have an important effect on the level of economic activity by affecting the level of AD
-Three objectives
o Price stability
o Low unemployment
o Economic prosperity and welfare of the people of Australia
8
Q
Price Stability
A
- Argued to be the most important objective of monetary policy.
- Keeping inflation low helps achieve the second objective of low unemployment
- Low inflation promotes business confidence and encourages investment which underpins economic growth
- Key objective of economic policy is to improve living standards
- Higher living standards can be achieved through economic growth which increases employment and raises national income
- Inflation undermines economic growth because it increases uncertainty, redistributes income, and encourages investment in non-productive assets
- Inflation can undermine the value of the currency and erode the value of people’s savings
- Inflation leads to higher interest rates which reduces private sector spending and lowers economic growth
- Inflation also reduces international competitiveness
- If Australia’s interest rate is higher than other countries, then Australia’s exports will be less competitive
- Achieving low inflation rate helps businesses in making sound investment decisions, encourages employment growth and preserves the value of the currency
- RBA has adopted a medium term strategy of keeping consumer price inflation between 2-3% over the medium term of the business cycle
9
Q
How does monetary policy work?
A
- Monetary policy works by affecting either the availability of credit (money supply) or its price (interest rates through the cash rate)
- RBA conducts monetary policy by changing short term interest rates through its open market operations with financial institutions
- Tool of monetary policy is the cash rate
- > Cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds between financial institutions and the reserve bank
- > RBA controls the supply of funds which financial institutions use to settle their transactions with each other
10
Q
Open Market Operations
A
- Consist of buying or selling of Australian government securities.
- e.g. If aim is to tighten monetary policy
- > RBA enter money market to create a shortage of cash by selling securities
- > Increases price of cash ( cash rate) and will cause other short term and long term interest rates to rise
- > Higher interest rates = price of borrowed money increased
- > Demand for credit contract, spending in the economy will fall.
- Raising the cash rate = policy stance is said to tighten
- > Otherwise known as contractionary stance
11
Q
Transmission Mechanism
A
- How changes in interest rates affect the level of economic activity
- Changes in cash rate influence expectations of private sector and affect level of domestic demand in economy
- Changes in cash rate will lead to changes in other interest rates.
- Changes in interest rates lead to changes in private spending -> affects output, employment and prices.
- Changes in interest rates affect:
- > Saving and investment decisions
- > Cash flow of households and firms
- > Wealth and asset prices
- > Exchange Rate
12
Q
Transmission Mechanism: Changes in Interest rate affecting Saving and Investment Decisions
A
- Rise in interest rates increase incentive to save
- > Increase return on deposits with financial institutions
- Increases cost of borrowing funds
- > Reduce spending by households
- > Reduce demand for finance
- Businesses often borrow to invest
- > Rise in interest rates reduce demand for investment funds
- > Affect profitability of investment projects
13
Q
Transmission Mechanism: Changes in interest rate affecting CASH FLOW OF HOUSEHOLDS AND FIRMS
A
- Affect cash flow position of both households and firms
- e.g. rise in mortgage rates,
- > reduce amount of income available for households to spend on other goods.
- If interest rates rise, firms have less cash to pay expenses
- > not likely to expand production / inc. employment
- Interest rates can have important effects on wealth and asset prices
- > Rise in interest rates makes shares less attractive vs bonds
- > Leads to a fall in stock market
- > Lowers wealth of households w/ share portfolios
- > Lead to decrease in spending
- Rise in interest rates also lower asset prices
- > Decreases people’s wealth
14
Q
Transmission Mechanism: Changes in interest rates affecting EXCHANGE RATE
A
- Fall in interest rates reduce capital inflow
- > Reduce demand for currency
- > Lead to currency depreciation
- Lower exchange rate will decrease export prices
- > Increase import prices
- > Increases net exports
- > Raise total spending in economy
- This is why monetary policy is powerful w/ free exchange rate
- > Lowering interest rates stimulates private spending
- > Increases net exports
15
Q
Contractionary Stance / Policy Transmission
A
- Rise in interest rates = contractionary effect in AD
- > Stops inflation from rising above 3%
- > Dampens private spending and investment spending
- > Increase cost of borrowing and reduce disposable income
- Higher interest rates will discourage households and firms from increasing their borrowing
- > Reduce current expenditure
- AE will fall
- > Help to slow economy’s growth rate
- AD will decrease, and shift to the left
- > GDP, employment and price level will fall
- > Spending will also fall
