Monetary Policy Flashcards
Interest rates affect house prices
As interest rates rise
- it is less affordable to pay back a mortgage
- reduction in number of people who can afford to enter the housing market and, for investors in housing for rental properties
- they increase the opportunity cost of investment compared to alternatives such as bank deposits, and house prices tend to fall or stagnate.
what happened when there were eight successive interest rate rises between 2005 and 2008
average mortgage repayments to rise significantly, reducing home purchase affordability and leading to a fall in house prices in some areas
homeowners were among the hardest hit
what happened after GFC when RBA reduced interest rate when inflation was not increasing and unemployment was rising?
- repayments on mortages were more affordable –> more income to purchase other goods and services
- mortgages became affordable
House prices rose
economic objectives of monetary policy
1 Full employment of the labour force
2 Stability of the Australian currency
3 Economic prosperity and welfare for the people of Australia
draw the demand for money curve
what is the opportunity cost of holding money
the interest rate
why does the money demand curve slope downwards?
when interest rates on CGS and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high
desirable and undersiable characteristic of money
it is liquid and you can easily use it to buy goods, services or financial assets.
it earns either no interest or a very low rate of interest
two variables that can shift the money demand curve
- The real GDP
- Price level
- Financial innovation e.g. ATMs,EFTPOS, internet banking
Describe how real GDP can shift the money demand curve
increase in real GDP –> buying and selling goods and services increase –> increased demand in money as a medium of exchange
describe how price level shifts the money demand curve
higher price level increases the quantity of money required for a given amount of buying and selling.
Repurchase agreements have an advantage over the outright sale of bonds and securities because
the repurchase agreement market is very liquid.
how is the overnight cash rate determined?
if banks and financial institutions require additional funds or wish to lend surplus funds –> this will influence demand + supply of funds
what is the exchange settlement account
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.
when do most interbank settlements occur?
90% of interbank settlements occur during the day: Real-Time Gross Settlement (RTGS),
Although most inter-bank payments are settled during the day, at the end of each day
any unsettled transactions must be settled via the exchange settlement accounts
what happens to overnight balances?
RBA pays interest on overnight balances, but as the rate of interest earned on these funds is 0.25 per cent below the cash rate banks usually try to minimise overnight balances and lend out any surpluses they may have
what do banks with surplus funds in their account do?
Banks with surplus funds in their accounts are willing to lend it overnight to other banks that are short of funds, as financial institutions are not allowed to go into overdraft.
The interest rate charged on these loans is set at 0.25 per cent above the overnight cash rate.
To avoid a rise in cash rate, what does the RBA do
RBA avoids a rise in the cash rate by making repurchase agreements with the banks. It lends them cash, at an interest rate equal to the cash rate, for an agreed period of between one and 90 days, using Commonwealth, state or certain other financial instruments as security.
what do banks do when they borrow from the RBA?
The banks deposit the funds they receive from the RBA, which increases the banks’ reserves
The banks loan out most of these reserves, which creates new demand deposits and expands the money supply
If the RBA decides 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.
To reduce the cash rate the RBA 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 instruments, this increases cash reserves held by financial institutions and subsequently, as the level of liquidity rises, the rate of interest falls.
OR RBA would not sterilise a surplus of overnight funds
If the RBA decides to raise the cash rate it will
- borrow cash from the banks through reverse repurchase agreements OR
- Outright sale bonds and securities
This will reduce financial reserves held by banks and other financial institutions and subsequently increase interest rates.
- the RBA would not offset an overnight shortage of exchange settlement funds.
The RBA will adjust the
availability of overnight funds to whatever level is required to keep interest rates at their targeted level
what does this figure show
shows interest rate targeting
the money supply will be adjusted to whatever level is necessary to keep the rate of interest at the rate targeted by the RBA. In this figure the target rate of interest is 7 per cent
The equilibrium is 1800. 1800 money supply is required to keep interst at 7
what is monetary targeting
It was used by RBA in the 70s and 80s. Monetary policy was used to control the size and growth rate of money supply
under monetary targeting,
what effect would increasing and decreasing money supply have?
increasing money supply –> more funds were available
decreasing money supply –> reduced availability of funds
the money supply has become increasingly difficult to target in Australia and many other countries. This is due to
financial innovation, the huge growth of credit and the growth of the private sector’s ability to affect the money supply via private bonds, securities and loans
abandoned in the 1990s, now use interest rate targeting
distinguish between the loanable funds model and money market model
the loanable funds model is concerned with the long-term real rate of interest and the money market model is concerned with the short-term nominal rate of interest.
The long-term real rate of interest is the interest rate that is most relevant when
savers consider purchasing a long-term financial investment such as a corporate bond. firms which are borrowing to finance long-term investment projects
households who are taking out a mortgage loan
conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because
it is the interest rate most affected by increases and decreases in liquidity
The effect of a change in the cash rate on long-term interest rates is
usually smaller than it is on short-term interest rates and the effect may occur after a lag in time.
what is aggregate demand
the total level of spending in the economy.
how can interest rate affect consumption?
Encourages saving and discourages borrowing (discourages current and future consumption)
net borrowers: higher interest rate –> lower future income
substitution effect will create a negative income effect
what complicates the way interest rate affects consumption?
Households can use their savings to buy other assets such as real estate or shares, or to contribute to superannuation funds.
change in interest rates may have more of an effect on the composition of households’ existing wealth
how will interest rate affect net savers?
uncertain
substitution effect works to discourage current consumption but there will be a positive income effect
higher interest rate –> increase future income –> increases wealth –> encourages current and future consumption
how will interest rate affect net savers?
what happens is substitution effect is stronger than the income effect?
. If the substitution effect is stronger than the income effect, current consumption will still fall and saving will increase.
If, however, the income effect is stronger, there will be a rise in current consumption and a fall in saving.
how will interest rate affect investment spending?
increases the cost of borrowing
increased opportunity cost of using profits if interest rates rise
how will interest rate affect net exports?
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.
dynamic aggregate demand and aggregate supply model that takes into account two important facts about the economy
(1) the economy experiences continuing inflation, with the price level rising every year,
(2) the economy experiences long-run growth, with the long-run aggregate supply (LRAS) curve shifting to the right every year.
several reasons why aggregate expenditure usually increases
As the population grows and incomes rise, consumption will increase over time.
as the economy grows firms expand capacity and new firms are established, increasing investment spending.
an expanding population and an expanding economy require increased government services, such as more teachers and police officers, so government purchases will expand.
draw a diagram of effect an expansionary monetary policy will have on the economy
explain this diagram
first year: economy is at potential GDP, $1000 and price level 100
2nd yr, LRAS increases to $1100 BUT AD only increases from AD1 to AD2(w/o policy), the economy will be at macroeconoimc equilibrium at B (where AD2(w/o policy) intersects with SRAS2), below potential GDP at C (where AD2(w/o policy) intersects with LRAS2) –> firms are operating at less than their normal capacity, below full employment –> Incomes and profits will fall, firms will begin to lay off workers and the unemployment rate will rise.
By lowering interest rate, increase in consumption, investment and net exports shift AD2(w/o policy) to AD2 (with policy)
what is a recognition lag
since it may take months for data to be gathered and analysed, RBA may not immediately recognise the need to tighten or loosen the monetary policy
does the monetary policy have an implementation lag?
No, decided montly
what is the impact lag in terms of the monetary policy
the time it takes for interest rate changes to affect real GDP
investment by its nature cannot be changed quickly—most investment projects are already committed to or are ongoing, and it is only proposed projects that may be altered. Therefore the full impact of a monetary policy change may take up to two years, or sometimes longer.
draw a diagram of the effect of a contractionary monetary policy
describe this
Economy at equilibrium at potential GDP at $930 and Price level of 100 in year 1
in Year 2, LRAS1 shifts to LRAS2, SRAS1 shifts to SRAS2, AD1 shifts to AD2 (w/o policy), SR equilibrium at B, but this above potential GDP
increase interest rate –> reduce aggregate demand –> AD2(w/o policy) to AD2(w policy), equilibrium at potential GDP at C
Second, monetary policy is usually more effective at
slowing down the economy
High rates of interest will effectively reduce most components of aggregate demand—new investment will fall, some consumer spending will decline and earnings from exports will fall due to the higher exchange rate that accompanies higher interest rates.
why is an expansionary monetary policy less effective?
During a recession business confidence is at a very low level
- Businesses will be unwilling to borrow money for investment when they are uncertain of their own viability, and are uncertain about the ability to generate sufficient profits to repay loans.
Households, given uncertainty and fearing low wages or even unemployment, may wish to increase their savings or reduce debt by reducing consumption.
example of how expansionary monetary policy is less effective
a number of countries experiencing severe recessions after the 2007–2008 GFC, nominal interest rates were zero, or almost zero, but this wasn’t sufficient to restore borrowing or economic growth.
when the monetary policy is tightened, what sectors of the economy does it impact the more?
increase in interest rate –> australian assets become more profitable –> $AU appreciates –> agriculture, manufacture and service sector lose international competitiveness
when the monetary policy is tightened, who experiences a greater burden?
marginal borrowers and lower income earners who generally have little savings do not benefit, and face higher interest repayments on loans, which can often impose severe hardship
cf people with savings benefit
why is monetary policy a blunt instrument
While it can be very effective in achieving its policy goal, the impacts on people are unequal.
what is another shortcoming to the monetary policy regarding financial institutions?
financial institutions in Australia are not required to alter their interest rates when the RBA changes monetary policy –> independent moves can prevent the RBA from implementing monetary policy effectively
e.g. During GFC major Australian banks still experienced a fund shortage –> from early 2008 and continuing through to the end of 2010 all of the major banks in Australia increased their interest rates independently of the RBA numerous times—moving outside the RBA’s target range.
should the RBA have an inflation target
why is it beneficial?
- provides a benchmark to measure performance
- households and firms can form accurate expectations of future forecast –> improve their planning
- institutionalise good monetary policy –> new board members would stick to the inflation target
what do the opponents to inflation targeting argue?
- numerical target for inflation reduces the flexibility of monetary policy to address other policy goals, such as unemployment, economic growth or exchange rate management.
- Second, inflation targeting assumes that the RBA can accurately forecast future inflation rates, which is not always the case.
case for RBA independence
To avoid inflation
- . Government will be tempted to sell bonds to RBA rather than public. RBA purchases these bonds –> money supply increases –> inflationary pressures rise
- if gov controls central bank, use it to further political interests e.g. difficult to be elected during high unemployment –> tempted to decrease interest rate –> inflationary pressures rise
what happened in November 2007?
During the lead-up to the November 2007 federal election in Australia the RBA increased interest rates—the first time it has ever done so during an election campaign, confirming its independence.
Case against RBA independence
Members of RBA do not have to run for election, they are not held accountable by voters - democratic system?
Argued RBA should act like executive branch- gov should
- members of RBA would serve as long as gov wanted them to
- If gov didnt like monetary policy, could dismiss and replace members
- When the government ran for re-election the voters would have an opportunity to express their approval or disapproval of the government’s actions regarding monetary policy.
