Monetary Policy (ch 13)

Question 0

What are the main causes of interest rate fluctuations?

Answer 0

1) level of economic activity
2) inflation
3) overseas economic activity
4) RBA monetary policy
5) public sector

Question 1

Define interest rate

Answer 1

The cost of borrowing, payment from borrowers to lenders for use of funds and a reward for savings.

Question 2

Define monetary policy

Answer 2

Actions taken by the reserve bank to affect monetary and financial conditions in the economy by affecting the price of money and credit.

Question 3

What are the three main objectives of the RBA?

Answer 3

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

Question 4

What happens to IR as economic growth increases?

Answer 4

IR increases as economic growth increases. Periods of economic growth are characterized by times of higher inflation. RBA’s main objective is inflation targeting, therefore as economic growth increases, inflation will increase and RBA will respond by increasing IR.

Question 5

Explain how the RBA implements contractionary monetary policy

Answer 5

• They increase the cash rate to decrease aggregate demand, thereby decreasing GDP and price level.
• To slow economy down and dampen inflationary expectations)
• Higher IR will curb spending and shift AD to the left
• this decreases price level but has a smaller impact on output

Question 6

Explain how the RBA implements expansionary monetary policy

Answer 6

• RBA lowers the cash rates to stimulate the economy and increase spending
• this shifts AD to the right and increases real GDP and employment
• price level increases but not as much as rise in output given excess capacity in economy.

Question 7

Which areas of the economy does change in interest rates affect? (5)

Answer 7

1) consumption
2) investment
3) exchange rates
4) inflationary expectations
5) wealth and asset prices

Question 8

How does changes in interest rates effect savings?

Answer 8

• rise in interest rates increase the attractiveness of saving as it increases the reward for postponing consumption
• this encourages households to defer consumption spending
• increase in interest rates will also causes existing borrowers to have less liquidity (e.g if mortgage rates rise households have less to spend on other things)
• household who don’t owe money enjoy an increase in their income (from higher pay on assets)

Question 9

How does changes interest rates affect investment ?

Answer 9

• In making investment decision, businesses compare the anticipated returns on a project
• returns higher than IR, project viable
• higher interest rates reduce the number of investment projects

Question 10

How does a fall in IR affect the exchange rate?

Answer 10

Higher interest rates will encourage an inflow of financial capital leading to currency appreciation, forcing increased Aus export prices and decrease import prices.

Question 11

How does a increase in interest rates affect wealth and asset prices

Answer 11

A rise in interest rates will make shares less attractive compared to bonds
• decrease in asset prices such as property

Question 12

Strengths of monetary policy (4)

Answer 12

1) flexibility
2) has greater political neutrality
3) very effective during boom periods
4) it’s most effective under free exchange rate

Question 13

List the weakness of monetary policy (4)

Answer 13

1) time lags
2) monetary is less effective during a recession
3) blunt instrument
4) ineffective with cost push inflation

Question 14

How is greater political neutrality a strength of MP?

Answer 14

RBA is an independent authority and therefore decisions made are based on economic rather than political reasoning.

Question 15

Why is MP effective during boom?

Answer 15

Tighter monetary policy has greater force because higher interest rates have more direct effect on economic decisions than lower rates.

Question 16

Effective under free exchange rate as a strength of MP

Answer 16

A cut in interest rates will cause a fall in capital inflow causing depreciation in value. (Talk about effects on imports and exports)

Question 17

How is time lags a weakness of MP

Answer 17

1) recognition, decision and action lag (INSIDE LAG)
2) effect (OUTSIDE) because works through interest rates to affect level of aggregate demand rather than gov spending or taxation.

Question 18

Why is “blunt” instrument a weakness of monetary policy?

Answer 18

It falls unevenly on sectors of economy

E.g. Heavily on housing industry and motor vehicle industry

Question 19

Why is MP ineffective with cost push inflation?

Answer 19

A rise in interest rates leads to an increase in business costs