Monetary Policy

Question 1

What is monetary policy?

Answer 1

The actions taken by central banks (such as the Reserve Bank of Australia) in the pursuit of macroeconomic goals.

The goals of monetary policy, according to the Reserve Bank Act, 1959:

1. Full employment of the labour force.
2. Stability of the Australian currency.
3. Economic prosperity and welfare forth people of Australia.

Inflation targeting = Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Question 2

The demand for money:

Answer 2

The money demand curve is downward sloping to show the inverse relationship between the interest rate on financial assets and the quantity of money demanded.

The interest rate on financial assets is the opportunity cost of holding money.

• Low interest rates reduce the opportunity cost of holding money.
• High interest rates increase the opportunity cost of holding money.

Question 3

Shifts in the money demand curve:

Answer 3

Changes in variables other than the interest rate cause the money demand curve to shift.

The two most important variables that shift the money demand curve are:

1. Real GDP.
2. The price level.

Question 4

How the RBA manages the supply of cash:

Answer 4

The RBA uses open market operations to sterilise liquidity changes in the financial system, in order to keep the interest rate the same.

Open market operations (OMOs): The RBA purchasing or selling financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements.

Question 5

To reduce the cash rate, the RBA…

Answer 5

publicly announces that it intends to do so.

The RBA will then either:

• not sterilise an overnight surplus, or
• offer to buy back repurchase agreements, or make outright purchases of bonds.

When the RBA pays for the bonds, this increases cash reserves held by financial institutions and the rate of interest will fall.

Question 6

To increase the cash rate, the RBA…

Answer 6

publiclyannounces that it intends to do so.

The RBA will then either:

1. not sterilise an overnight shortage, or
2. use reverse repurchase agreements or carry out the outright sale of bonds.

When the RBA receives payment for the bonds, this reduces cash reserves held by financial institutions and the rate of interest will rise.

Question 7

Equilibrium in the money market:

Answer 7

Monetary targeting = Conducting monetary policy to control the size and rate of growth of the money supply.

The RBA no longer uses monetary targeting, and instead uses interest rate targeting.

Question 8

How interest rates affect aggregate demand?

Answer 8

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand:

1. Consumption (through borrowing costs).
2. Investment (through borrowing costs).
3. Net exports (through changes in the exchange rate)

Question 9

Expansionary Monetary Policy:

Answer 9

In the short run:

• Prices increase and output increases.

In the long run:

• Prices increase even further but output is unchanged.

Thus, in the long run, expansionary monetary policy only causes inflation.

Question 10

Contractionary Monetary Policy:

Answer 10

In the short run:

• Prices fall and output falls.

In the long run:

• Prices fall even further but output is unchanged overall.

Thus, in the log run, contractionary monetary policy only reduces prices.

Contractionary monetary policy is used during periods of high or rising inflation rates.

Question 11

Is monetary policy always effective and fair?

Answer 11

• Time lags may reduce the ability of monetary policy to impact on the economy at the appropriate time.
• Monetary policy is more effective at reducing the rate of inflation during an economic boom than it is at stimulating aggregate demand during a contraction or recession
• Monetary policy is a ‘blunt instrument’ and does not affect all people or industries equally:
• With contractionary monetary policy:
  
  • Savers can benefit and increase their spending.
  • Borrowers (individuals and businesses) face higher interest repayments on loans.
  • Low income earners are often ‘marginal’ borrowers, and may be at a higher risk of loan defaults.
• With expansionary monetary policy borrowers benefit more than savers

Question 12

Expansionary and contractionary monetary policy:

Answer 12