Monetary Policy

Question 1

What is monetary policy?

Answer 1

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.

Question 2

What do interest rates represent?

Answer 2

Interest rates represent the cost or price of money and credit.

Question 3

How does the Reserve Bank indirectly affect interest rates?

Answer 3

The Reserve Bank indirectly affects interest rates throughout the economy by its ability to set the interest rate on overnight loans in the money market. This is called the cash rate.

Question 4

What are some reasons why monetary policy is regarded as being more important than fiscal policy?

Answer 4

-Is flexible.
-Effects all consumers and businesses (where fiscal has more specific targets).
Effects exchange rates.
-Has an effect on output, employment and the price level.

Question 5

What is the role of the financial sector?

Answer 5

• Financial markets are an intermediary between savers and investors, or lenders and borrowers of funds. They serve an intermediary role.
• They are termed financial intermediaries because they ‘come between’ or ‘mediate’ between people who have surplus funds and those who want to borrow funds.

Question 6

What is the central bank responsible for?

Answer 6

The central bank is responsible for administering monetary policy and the maintenance of overall financial stability.

Question 7

What two things do interest rates represent?

Answer 7

1. The price of credit- cost of borrowing.
2. The reward for saving- return for putting money in a financial institution.

That is, people borrow and must pay for this. Likewise, people save and must be rewarded for this.

Question 8

Why is the financial sector important?

Answer 8

The financial sector is important because it is liked to every sector of the economy. A stable financial system is a key ingredient in ensuring sustainable economic growth.
A crisis such as the failure of financial institutions can quickly lead to a major economic recession. This is precisely what led to the GFC of 2008-09 and subsequent world recession.

Question 9

Why do interest rates have a significant impact on the level of spending and economic activity?

Answer 9

Interest rates are a major factor affecting consumption and investment. High interest rates discourage spending and investment and low interest rates encourage spending and investment.

Question 10

What are nominal rates vs. real interest rates?

Answer 10

Nominal rates are the rates that are not adjusted for the rate of inflation.

Real interest rates are nominal interest rates minus the rate of inflation.

Question 11

What are two reasons why interest rates vary between different types of borrowing and lending instruments?

Answer 11

1. Risk involved- the greater the risk, the higher the return (higher interest rate).
2. Length of time- the longer the term (how long you leave your money in the FI) the higher the return.

Question 12

When will interest rates rise/fall?

Answer 12

Interest rates rise when there is an increase in the demand for funds or a decrease in the supply of funds.

Interest rates fall when there is a decrease in the demand for funds or an increase in the supply of funds.

Question 13

Give some examples that would result in an increase in interest rates.

Answer 13

• An increase in business/consumer confidence or an increase in economic activity would increase the demand for loans.
• A government budget deficit could cause a decrease in the supply of loanable funds (crowing out).

Question 14

Give some examples that could result in a decrease in interest rates.

Answer 14

• A decrease in business/consumer confidence would decrease the demand for loanable funds.
• An increase in private savings or a government budget surplus would increase the supply.

Question 15

What is the basic aim of monetary policy?

Answer 15

The basic aim of monetary policy is to achieve sustainable growth in the long run by controlling inflation. Inflation reduces the value of money and undermines the confidence of households and firms.
The RBA’s main policy instrument is the cash rate.

Question 16

What are the three objectives of monetary policy?

Answer 16

1. The stability of the currency (price stability/low inflation).
2. The maintenance of full employment (low unemployment).
3. The economic prosperity and welfare of the people of Australia.

Question 17

What is the relationship between low inflation, economic growth and full employment?

Answer 17

Price stability is the most important objective of monetary policy. The reason for this is that it promotes financial stability and protects the value of money. Keeping inflation low also helps to achieve low unemployment because low inflation promotes business confidence and encourages investment which underpins economic growth.

Question 18

What are the costs of high inflation?

Answer 18

• Rise in unemployment (can lead to stagflation due to high interest rates, therefore low investment and high unemployment).
• Reduces international competitiveness (exports become more expensive).
• Decrease in domestic production and increase in imports.

Question 19

What are the benefits of low inflation?

Answer 19

• Low unemployment.
• More investment (greater business confidence).
• More competitive international market (cheaper exports).
• Increase in domestic production and decreased imports.

Question 20

What is the RBA’s inflation target?

Answer 20

Between 2 and 3%.

Question 21

Distinguish between the headline and underlying rate of inflation.

Answer 21

The headline rate is measured by the consumer price index (CPI) and is the most common measure.

Underlying inflation is headline inflation minus volatile and seasonal elements.

Question 22

Why does monetary policy have to be forward looking?

Answer 22

The Reserve Bank’s actions will affect the economy in 6-12 months time, so they need to assess the state of the economy and need to know the position of the economy in the business cycle.
e.g. If the RBA believes that inflationary expectations are rising, they will increase interest rates before the inflation rate increases.

Question 23

What occurs on the first Tuesday of each month?

Answer 23

The nine-member Board meets to review indicators and are briefed on current economic conditions, after which they announce what the target cash rate will be for the next month.

Question 24

How does the RBA use OMOs to tighten monetary policy?

Answer 24

Open market operations consist of buying or selling Australian government securities. If the aim is to tighten monetary policy, the RBA enters the market to create a shortage of money by selling securities. This will increase the price of cash (cash rate) causing interest rates to rise.

Question 25

How does the RBA use OMOs to loosen monetary policy?

Answer 25

The RBA will use market operations to create surplus by buying securities. This will reduce the price of money and place downward pressure on interest rates. The cost of borrowing will fall, demand for credit will rise and spending and economic activity will expand.

Question 26

How and why was monetary policy was used in Australia between 2010 and 2016?

Answer 26

• During 2010, the cash rate was raised- the economy was growing at an unsustainable rate and inflation had begun to rise.
• By 2011, the mining/construction boom was ending causing a collapse in business investment. Therefore, the RBA adopted an aggressive expansionary stance. The cash rate was cut 12 times to reach a historically low level of just 1.5% by August 2016.

This stance was prompted by below average levels of economic activity and very low levels of inflation (below 2%) and rising unemployment.
Policy statements made by the RBA included ‘global economy growing at below average pace’ ‘falling terms of trade’ ‘large decline in business investment’ ‘subdued growth in labour costs’ and ‘low levels of inflation’.

Question 27

What is the transmission mechanism?

Answer 27

How changes in interest rates affect the level of economic activity is referred to as the transmission mechanism.

Question 28

What four things do changes in interest rates effect?

Answer 28

• Saving and investment decisions.
• The cash flow of households and firms.
• Wealth and asset prices.
• The exchange rate.

Question 29

How will a change in interest rates affect the decisions of households and businesses?

Answer 29

A rise in interest rates will increase the incentive to save because it will increase the return on deposits with financial institutions. At the same time, a rise in interest rates increases the cost of borrowing funds and so will reduce the demand by households for housing and durable goods.

Businesses often borrow to invest, so a rise in interest rates will reduce the demand for investment funds because it will affect the profitability of many investment projects.

So, a rise in interest rates will decrease both consumption and investment.

Question 30

How do interest rates affect the cash flow of households and firms?

Answer 30

A rise in mortgage rates for example, will reduce the amount of income available for households to spend on other goods and services.
If borrowing costs increase for firms then this will also affect a firm’s cash position. Most firms affect a firm’s cash position. Most firms are net borrowers, which means that interest payments on their overdraft and loan accounts represent a significant proportion of their profits. -> If interest rates rise then firms will have less cash to pay expenses and are not likely to expand production or increase employment.

Question 31

How do interest rates affect wealth and asset prices?

Answer 31

The most important assets are shares and property. A rise in interest rates makes shares less attractive compared to bonds and this leads to a fall in the stock market.
Share prices begin to decline, which lowers the wealth of households with share portfolios and ultimately will lead to a decrease in consumption spending.
A rise in interest rates will also have a negative effect on property prices A fall in property prices will reduce household wealth which will decrease consumption.

Question 32

Why is monetary policy especially effective when teamed with a floating exchange rate?

Answer 32

A fall in interest rates will reduce capital inflow (foreign investment), which will reduce the demand for the currency, and will lead to a currency depreciation.
A lower exchange rate will decrease export prices and increase import prices. This will increase net exports and again raise total spending in the economy.
This is why monetary policy is considered to be quite powerful when coupled with a free exchange rate.
Lowering interest rates not only stimulates private spending (consumption and investment) but also increases net exports (X-M).

Question 33

What does it mean when the RBA adopts and neutral stance?

Answer 33

This means setting interest rates at a level that is neither stimulatory nor contractionary. A neutral stance implies that the economy is usually close to a natural rate of employment, and inflation is between 2-3%.

Question 34

What is the intention of contractionary/tight monetary policy?

Answer 34

The intention is to contract the economy which will decrease aggregate demand or aggregate expenditure. To do this, the Reserve Banks needs to increase the cash rate. A rise in interest rates discourages investment spending leading to a fall in aggregate expenditure and a decrease in the equilibrium level of income.

Question 35

What is the result of high interest rates discouraging both household and firms from borrowing?

Answer 35

• Investment will fall (decreased cash flow).
• Consumption will fall (decreased cash flow).
• Mortgage and credit card payments increase due to increased credit costs.
• Foreign investment flows increase (better returns).
• Currency will appreciate (higher demand for currency).
• Export earnings fall as exports are more expensive.

Question 36

Use an Investment Demand Curve and an AE model to show the effect of rising interest rates.

Answer 36

Increase in interest rates -> decrease in investment.

Decrease in AE, decrease in income/GDP.

Question 37

What is the intention behind expansionary (loose) monetary policy?

Answer 37

Loose monetary policy will encourage spending and investment due to lower interest rates. This leads to an increase in aggregate demand/AE.

Question 38

Why will a decrease in interest rates have an expansionary effect on the economy? What will lower interest rates lead to?

Answer 38

• Increase in consumption?
• Increase in investment (business).
• Increase in cash flow.
• Decrease in mortgage and credit card payments (decrease in cost of credit).
• Decrease in foreign investment (not as attractive to invest).
• Decrease in demand for $AUD (therefore a depreciation).
• Increase in export earnings (more competitive).
• Increase in AD (increase in income, increase in output, decreased unemployment).

Question 39

Use an investment demand curve and an AE model to show the effect of falling interest rates.

Answer 39

Decrease in interest rates -> increase in investment.

Increase in AE, increase in income/GDP.

Question 40

Why does the RBA focus on price stability and has this approach been successful?

Answer 40

Inflation targeting means keeping inflation between 2-3%. This has been successful because keeping the inflation rate low means that it is possible to keep the economy growing for an extended period. Normal economic expansions end when the economy peaks- inflation becomes a problem and interest rates push the economy into a contraction.

Question 41

What is meant by transparent policy decision making?

Answer 41

Part of this new era of monetary policy was a move to make monetary policy more transparent. This means that the RBA believes it is important to announce and explain its policy decisions. This helps to make monetary policy more effective in controlling inflation by influencing expectations.

Question 42

Describe some of the recent trends in inflation and interest rates.

Answer 42

Price stability is an important objective for the reserve bank. The cash rate was quickly raised in 2007-08 as inflation increased due to the mining boom.
The global financial crisis of 2008-09 saw inflation tumble and interest rates followed suit.
The cash rate was again raised during 2010 as the economy recovered and inflation increased to above 3 per cent by mid 2011.
The mining construction boom ended in 2012 and economic activity and inflation began to fall. The reserve bank reacted by adopting an expansionary stance and reduced the cash rate from 4.75% to 1.5% by 2016.

Question 43

What are the four strengths of monetary policy?

Answer 43

Flexibility.
Political neutrality
Effectiveness in booms
Effectiveness when used in conjunction with a floating exchange rate.

Question 44

Explain how flexibility is a strength of monetary policy.

Answer 44

Arguably the greatest strength of monetary policy is its flexibility. Decisions about whether to raise or cut the cash rate are made every day by the RBA. Additionally, it does not require specific authorization by Parliament.
The RBA meets every month to asses the state of the economy which enables decisions to be made and implemented quickly.
The decision and implementation time lags are relatively short compared with fiscal policy.

Question 45

Explain how political neutrality is a strength of monetary policy.

Answer 45

The Reserve Bank is an independent authority and is not aligned to the government in power.
It is free of political bias. This means decisions are based on economic rather than political reasons.

Question 46

Explain how effectiveness in booms is a strength of monetary policy.

Answer 46

Monetary policy is more effective in the control of high levels of aggregate demand and inflation, than during a contraction.
Tighter monetary policy has a greater force because high interest rates have a more direct effect on economic decision than do lower rates.
Higher interest rates assume a very important role in the decisions of consumers in borrowing, or investors comparing the rate of return.

Question 47

Explain how effectiveness when used in conjunction with a floating exchange rate is a strength of monetary policy.

Answer 47

Changes in interest rates affect the interest rate differential with other countries which affects movements in financial capital (foreign investment). This will reduce the demand for the currency and lead to a depreciation.
Net exports will be stimulated as export prices fall and import prices rise.
Thus, an expansionary monetary policy will not only increase consumption and investment, but also INCREASE NET EXPORTS.
This effect of monetary policy on net exports, via the exchange rate, is an important part of the transmission mechanism.

Question 48

Weakness of monetary policy: Why is the outside lag for monetary policy longer than the lag for fiscal policy?

Answer 48

The inside lag for monetary policy is relatively short. This is an advantage compared with fiscal policy where the inside lag is long.

The outside lag refers to the time it takes for the policy to actually affect the level of economic activity- the effect lag.
The effect lag for monetary policy is longer than for fiscal policy, because monetary policy works indirectly through interest rates to affect the level of aggregate demand.
e.g.
After the global financial crisis of 2008-09, interest rates were lowered to very low levels but it took time before the private sector began to borrow and invest.

Fiscal policy is more direct as it changes either government spending or taxation which affects aggregate demand more quickly.

Question 49

Weakness: Why is monetary policy ineffective in a recession?

Answer 49

Monetary policy is more effective in a period where economic activity is high, than when the economy is in a contraction. Low interest rates may not be sufficient to stimulate private spending when economic conditions are pessimistic.

e. g. The cash rate was reduced below 2% during 2016 but business investment did not respond. If firms are pessimistic about economic conditions in the future, then they may not wish to borrow funds and invest even though the cost of money is relatively low (e.g. if someone has just lost their job, they won’t be likely to take out a loan for a house, even if interest rates are really low).
e. g. Another example was in the US during the GFC of 2008-09. The cash rate was reduced from 3.5% to just 0.25%, but its impact on the economy was negligible.

Question 50

Weakness: why is monetary policy referred to as a ‘blunt’ instrument?

Answer 50

Monetary policy is often regarded as a ‘blunt’ policy instrument. This means that monetary policy, unlike fiscal policy cannot be used selectively to target particular groups or sectors of the economy.
Changes in interest rates affect everyone.