Monetary policy Flashcards
What is monetary policy?
Refers to the interest rate decisions taken by the Reserve Bank of Australia to affect monetary and financial conditions within the economy, with the aim of achieving low inflation (price stability) and sustainable economic growth.
Financial markets
- Act as intermediaries between savers and investors
- E.g. financial institutions such as banks
- Borrow from firms or individuals with excess funds and lend to those who need funds
Main types of financial markets
Loan market
Bond market
Share market
Loan market
Business firms borrow money to buy capital equipment while households borrow for housing and cars
Bond market
Firms and governments sell bonds to raise finance (e.g. to finance a budget deficit
Share market
Firms can obtain finance for expansion by issuing new shares though the stock market
Key functions of money
- Means of exchange
- Unit of measurement
- Store of value
Main goal of the RBA
- Price stability
- Keeping inflation low to protect the value of money and promote stability in the financial system
What do interest rates represent?
- Represent the price of credit and the cost of borrowing money over a period of time
- Equates to the demand and supply of funds
- A large proportion of transactions are based on credit and borrowing, therefore changes in interest rates have a significant impact on the level of spending and economic activity
Nominal vs real interest rates
- Nominal rates: not adjusted for inflation
- Real rate: nominal rate minus the inflation rate
o Important influence on economic conditions involving borrowing and saving
o Shows how much borrowers actually pay and how much lenders receive in terms of purchasing power - Nominal rates tend to reflect changes in inflation
Why do the rates offered by the financial institutions to lenders will be much less than the rates charged by the same institutions for loans
- A major portion of the firms’ costs (including profit) are met by this differential
- Interest rates vary due to the reasons associated with the risk and maturity period of any given loan
- Risk arises because the future is uncertain
Long term/ short term interest rates
- Long term interest rates are usually higher than short term rates, because lenders need to be compensated for parting with their funds over a longer period
- A longer loan period equates with greater risk and greater uncertainty and therefore the interest rates should be higher than for a short term loan
Demand for loanable funds (DLF)
- The higher the real interest rate, the smaller the quantity of loanable funds demanded
- This is because the real interest rate represents the opportunity cost of funds
- Firms will be willing to demand more funds for investment at a lower real rate of interest
- ↑ rate, ↑ cost of borrowing, ↓ demand for loanable funds
Supply of loanable funds
- Main source of loanable funds is from saving
- As the real interest rate rises, there is more incentive to save
Factors that could increase the demand for loanable funds
- An increase in economic activity
- A government budget deficit
Factors that could decrease the supply of loanable funds
- A decrease in private saving
Factors that could decrease the demand for loanable funds
- A decrease in economic activity
Factors that could increase the supply of loanable funds
- Government budget surplus
- An increase in private saving
Aim of monetary policy
To achieve a sustainable growth rate in the long run by controlling inflation
Relationship between low inflation, economic growth and full employment
- Inflation reduces the value of money and undermines the confidence of households and firms
- High levels of inflation can have a negative effect on economic growth and living standards
- This is why low inflation is seen as a vital objective in achieving long term economic stability
Objectives of monetary policy
- Stability of the currency of Australia
- Maintenance of full employment
- Economic prosperity and welfare of the people of Australia
Benefits of low inflation
- Maintains the real value of money
- Protects the value of savings
- Keeps nominal and real interest rates low
- Promotes business confidence and productive investment
- Reduces uncertainty which promotes long term growth and job creation
- Promotes international competitiveness
- Does not distort income distribution
- Improves decision making