Monetary Policy

Question 1

Interest rates affect house prices

As interest rates rise

Answer 1

1. it is less affordable to pay back a mortgage
2. reduction in number of people who can afford to enter the housing market and, for investors in housing for rental properties
3. they increase the opportunity cost of investment compared to alternatives such as bank deposits, and house prices tend to fall or stagnate.

Question 2

what happened when there were eight successive interest rate rises between 2005 and 2008

Answer 2

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

Question 3

what happened after GFC when RBA reduced interest rate when inflation was not increasing and unemployment was rising?

Answer 3

1. repayments on mortages were more affordable –> more income to purchase other goods and services
2. mortgages became affordable

House prices rose

Question 4

economic objectives of monetary policy

Answer 4

1 Full employment of the labour force

2 Stability of the Australian currency

3 Economic prosperity and welfare for the people of Australia

Question 5

draw the demand for money curve

Answer 5

Question 6

what is the opportunity cost of holding money

Answer 6

the interest rate

Question 7

why does the money demand curve slope downwards?

Answer 7

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

Question 8

desirable and undersiable characteristic of money

Answer 8

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

Question 9

two variables that can shift the money demand curve

Answer 9

1. The real GDP
2. Price level
3. Financial innovation e.g. ATMs,EFTPOS, internet banking

Question 10

Describe how real GDP can shift the money demand curve

Answer 10

increase in real GDP –> buying and selling goods and services increase –> increased demand in money as a medium of exchange

Question 11

describe how price level shifts the money demand curve

Answer 11

higher price level increases the quantity of money required for a given amount of buying and selling.

Question 12

Repurchase agreements have an advantage over the outright sale of bonds and securities because

Answer 12

the repurchase agreement market is very liquid.

Question 13

how is the overnight cash rate determined?

Answer 13

if banks and financial institutions require additional funds or wish to lend surplus funds –> this will influence demand + supply of funds

Question 14

what is the exchange settlement account

Answer 14

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.

Question 15

when do most interbank settlements occur?

Answer 15

90% of interbank settlements occur during the day: Real-Time Gross Settlement (RTGS),

Question 16

Although most inter-bank payments are settled during the day, at the end of each day

Answer 16

any unsettled transactions must be settled via the exchange settlement accounts

Question 17

what happens to overnight balances?

Answer 17

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

Question 18

what do banks with surplus funds in their account do?

Answer 18

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.

Question 19

To avoid a rise in cash rate, what does the RBA do

Answer 19

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.

Question 20

what do banks do when they borrow from the RBA?

Answer 20

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

Question 21

If the RBA decides to change the cash rate

Answer 21

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.

Question 22

To reduce the cash rate the RBA would

Answer 22

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

Question 23

If the RBA decides to raise the cash rate it will

Answer 23

1. borrow cash from the banks through reverse repurchase agreements OR
2. Outright sale bonds and securities

This will reduce financial reserves held by banks and other financial institutions and subsequently increase interest rates.

3. the RBA would not offset an overnight shortage of exchange settlement funds.

Question 24

The RBA will adjust the

Answer 24

availability of overnight funds to whatever level is required to keep interest rates at their targeted level

Question 25

what does this figure show

Answer 25

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

Question 26

what is monetary targeting

Answer 26

It was used by RBA in the 70s and 80s. Monetary policy was used to control the size and growth rate of money supply

Question 27

under monetary targeting,

what effect would increasing and decreasing money supply have?

Answer 27

increasing money supply –> more funds were available

decreasing money supply –> reduced availability of funds

Question 28

the money supply has become increasingly difficult to target in Australia and many other countries. This is due to

Answer 28

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

Question 29

distinguish between the loanable funds model and money market model

Answer 29

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.

Question 30

The long-term real rate of interest is the interest rate that is most relevant when

Answer 30

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

Question 31

conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because

Answer 31

it is the interest rate most affected by increases and decreases in liquidity

Question 32

The effect of a change in the cash rate on long-term interest rates is

Answer 32

usually smaller than it is on short-term interest rates and the effect may occur after a lag in time.

Question 33

what is aggregate demand

Answer 33

the total level of spending in the economy.

Question 34

how can interest rate affect consumption?

Answer 34

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

Question 35

what complicates the way interest rate affects consumption?

Answer 35

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

Question 36

how will interest rate affect net savers?

Answer 36

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

Question 37

how will interest rate affect net savers?

what happens is substitution effect is stronger than the income effect?

Answer 37

. 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.

Question 38

how will interest rate affect investment spending?

Answer 38

increases the cost of borrowing

increased opportunity cost of using profits if interest rates rise

Question 39

how will interest rate affect net exports?

Answer 39

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.

Question 40

dynamic aggregate demand and aggregate supply model that takes into account two important facts about the economy

Answer 40

(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.

Question 41

several reasons why aggregate expenditure usually increases

Answer 41

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.

Question 42

draw a diagram of effect an expansionary monetary policy will have on the economy

Answer 42

Question 43

explain this diagram

Answer 43

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 AD_{2(w/o policy)} intersects with SRAS₂), below potential GDP at C (where AD_{2(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 AD_{2(w/o policy)} to AD2 (with policy)

Question 44

what is a recognition lag

Answer 44

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

Question 45

does the monetary policy have an implementation lag?

Answer 45

No, decided montly

Question 46

what is the impact lag in terms of the monetary policy

Answer 46

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.

Question 47

draw a diagram of the effect of a contractionary monetary policy

Answer 47

Question 48

describe this

Answer 48

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

Question 49

Second, monetary policy is usually more effective at

Answer 49

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.

Question 50

why is an expansionary monetary policy less effective?

Answer 50

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.

Question 51

example of how expansionary monetary policy is less effective

Answer 51

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.

Question 52

when the monetary policy is tightened, what sectors of the economy does it impact the more?

Answer 52

increase in interest rate –> australian assets become more profitable –> $AU appreciates –> agriculture, manufacture and service sector lose international competitiveness

Question 53

when the monetary policy is tightened, who experiences a greater burden?

Answer 53

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

Question 54

why is monetary policy a blunt instrument

Answer 54

While it can be very effective in achieving its policy goal, the impacts on people are unequal.

Question 55

what is another shortcoming to the monetary policy regarding financial institutions?

Answer 55

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.

Question 56

should the RBA have an inflation target

why is it beneficial?

Answer 56

1. provides a benchmark to measure performance
2. households and firms can form accurate expectations of future forecast –> improve their planning
3. institutionalise good monetary policy –> new board members would stick to the inflation target

Question 57

what do the opponents to inflation targeting argue?

Answer 57

1. numerical target for inflation reduces the flexibility of monetary policy to address other policy goals, such as unemployment, economic growth or exchange rate management.
2. Second, inflation targeting assumes that the RBA can accurately forecast future inflation rates, which is not always the case.

Question 58

case for RBA independence

Answer 58

To avoid inflation

1. . Government will be tempted to sell bonds to RBA rather than public. RBA purchases these bonds –> money supply increases –> inflationary pressures rise
2. 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

Question 59

what happened in November 2007?

Answer 59

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.

Question 60

Case against RBA independence

Answer 60

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.