Monetary policy - definitions Flashcards
Monetary policy
Operated by the RBA on behalf of the government and involves the manipulation of key financial variables in the economy, to achieve economic goals an increase living standards.
Cash rate
Is the interest rate that applies to borrowing and lending by banks in the overnight market.
OMOs
The RBA’s buying and selling of financial instruments, such as Australian government securities or repurchase agreements to participants in the cash markets.
Purchase of instrument injects cash into the market and reduces the cash rate. Vice versa.
Tightening of monetary policy
Involves the RBA announcing a higher target cash rate the afternoon of its monthly board meetings. Thus, increase in interest rate.
Loosening of monetary policy
Involves the RBA announcing a lower target cash rate the afternoon of its monthly board meetings. Thus, decrease in interest rate.
Transmission mechanism
The way a change to the cash rate affects economic activity and there are two general stages to consider:
- Interest rates
- Economic activity
Cost of credit channel
Tighter monetary policy results in higher interest rates making it more costly to borrow money, meaning higher cost of credit will provide households with greater incentive to save. Higher cost of credit reduces consumption from households and business are likely to reduce or delay investment. Reduction in consumption and investment works to reduce AD economic growth and inflationary pressures in the economy.
Cash flow Channel
Higher interest rates negatively impact those in the economy with existing variable rate loans, particularly ‘borrower households’ who will immediately suffer a drop in cash flow, as more disposable income needs to be used to repay interest, Net lenders however will benefit. Households will reduce consumption, as well as the business sector, spending more to service potential loans.
Asset prices and wealth channel
With higher interest rates, the price or value of assets, such as housing and shares, are likely to decrease because the demand for various types of assets is likely to fall, thus reducing the average wealth of households and reduces consumption and AD, economic activity and inflationary pressures. The ability of the households to borrow more money will decrease as riskiness increases.
The exchange rate channel
The exchange rate will generally be positively correlated to interest rates, such that a rise in interest rates is expected to cause an appreciation of the exchange rate, as higher domestic interest rates attract foreign funds seeking relatively higher rates of return on their investments. As foreign funds enter Australia, they are exchanged into AUD, increasing the demand and thus exerting upward pressure on the value of AUD. A higher interest rate reduces the international competitiveness of Australia’s tradeables sector reducing net exports, and decreasing economic activity and inflationary pressure.
Availability of money and credit channel
The availability of money and credit in the economy is likely to fall in times of higher interest rates because it makes it less likely that some households or businesses will meet the landing criteria established y financial institutions as the risk increases. Financial institutions are more likely to reduce the number of loan approvals to both households and businesses when interest rates rise, thus reducing AD, economic activity and inflationary pressure.
Role of inflationary expectations
Households and businesses will typically have some expectation of where they think inflation will be in the near term and these ‘expectations’ can, and do, influence their decision making. Only when consumers and businesses believe that inflation is ‘under control’ will their spending and saving decisions be made in a way that doesn’t risk spiraling inflation that is fueled by expectations alone.
Monetary policy neutrality
When the cash rate is at a level where it is neither working to stimulate nor contract the economy. 3%
Expansionary monetary policy stance
Where the setting of the target cash rate is low enough to be stimulating AD an increasing inflationary pressure, occurring when the cash rate is below 3%.
Restrictive monetary policy
Where the setting of the target cash rate is high enough to be restraining AD and reducing inflationary pressure.
