Unit 4 AOS 1 - Chapter 5: Managing Aggregate Demand Using Monetary Policy

Question 1

What is monetary policy?

Answer 1

Monetary policy is an AGGREGATE DEMAND POLICY operated by the Reserve Bank of Australia (RBA). It is designed to regulate business activity (smooth the business cycle) and it does this generally by changes to the OFFICIAL CASH RATE (interest rates) which in turn impacts the cost, availability and demand for credit (borrowed funds/money).

Question 2

What does monetary policy rely most heavily on?

Answer 2

It relies most heavily on changes in interest rates to alter the cost, availability and demand for credit (borrowed money).

Question 3

What are interest rates?

Answer 3

Interest rates refer to the annual cost of borrowing credit or
the annual return on invested savings. Rates are closely related to the nation’s inflation rate and are largely determined at equilibrium in financial markets by the forces of supply (by savers) and demand for credit (by borrowers).

Question 4

How can interest rates help to achieve the government economic goals?

Answer 4

Because interest rates have the capacity to alter the level of AD, they can help to achieve the government’s goals of:
. low inflation
. strong and sustainable economic growth
. and full employment
(ultimately improving Australia’s living standards).

Question 5

What is monetary policy regarded as?

Answer 5

Overall, monetary policy is regarded as a fairly flexible instrument in that it can change its stance at quite short notice without requiring the approval of parliament.

Question 6

What is money?

Answer 6

Money is a commodity and includes coins and notes, as
well as bank and other deposits in financial institutions held
by the public. It fulfils various functions including a commonly regarded measure of value, store of value and standard of deferred payments.

Question 7

How is the money supply measured in Australia?

Answer 7

In Australia, the money supply or volume of money is measured by the RBA and consists of the following components:

. The volume of coins and notes (cash or money base) held by the non-bank public and deposits of banks with the RBA

PLUS

. The volume of both operating and fixed bank savings deposits

EQUALS

. M3 (one commonly quoted measure of the volume of money)

PLUS

. Net deposits of savings in non-bank financial institutions (NBFIs)

EQUALS

. Broad money (a wide or comprehensive measure of the money supply or volume of money).

Question 8

Why is knowing changes in money relevant?

Answer 8

Knowing changes in the volume of money is relevant when considering factors that affect the level of economic activity and the setting of monetary policy.

Question 9

Explain the process of credit creation.

Answer 9

The RBA supplies as much currency to the banks as is required to meet the demand. However, these days wee are slowly becoming a cashless society. Today the largest proportion of Australia’s volume of money is deposits of different types with financial institutions. Bank deposits are mostly recorded in passbooks as accounting entries. These deposits are not backed up with piles of cash sitting idly in bank vaults. Instead, deposits partly come about through the process of credit creation conducted by financial institutions.

Question 10

More on the process of credit creation.

Answer 10

Eg.
. When a deposit is made, part of the deposit is put aside to ensure that the bank retains enough liquidity (assets easily converted in cash).
. The remainder of your savings deposit is lent by the bank to some creditworthy borrower you do not even know. After paying interest to the bank, this customer then uses the credit to purchase a good or service by means of a cheque or electronic funds transfer.
. The seller of goods and services, upon receiving the money, then makes a new deposit within the financial sector, causing the level of total deposits to grow (now consisting of both your deposit plus the one by the seller).

Question 11

What happens when the volume of credit grows?

Answer 11

Whatever way credit is created, when the volume of credit grows quickly, this fuels some types of household and business expenditure. AD (especially C + I) is affected, as is the level of domestic economic activity.

It is even possible that inflation may result from too much credit or money in an economy that is already operating at its capacity.

Question 12

What happens when there is too little credit?

Answer 12

It is also true that too little credit growth can strangle activity and bring on recession.

Question 12

How can the RBA help ensure that there is just enough credit?

Answer 12

The deliberate regulation by the RBA of interest rates on savings deposits and on credit (loans), is one way of ensuring that the growth in AD and economic activity is neither too fast nor too slow to ensure stability. This is an important stabilising feature of monetary policy

Question 13

What is monetarism?

Answer 13

Monetarism is an economic theory that emphasises the key role played by the volume of money in influencing output, employment and prices.

Question 14

What is the financial sector and the capital market?

Answer 14

The capital market involves the borrowing (demanding) and lending (supplying) of credit at a price or cost which is called the rate of interest. Banks and other types of financial institutions such as building societies, managed funds, superannuation funds, credit unions, insurance companies, finance companies and the stock exchange play a pivotal role in this market.

The RBA heads the financial sector and uses its monetary policy to help avoid inflation and improve domestic economic stability.

Question 15

Explain the structure of Australia’s financial sector.

Answer 15

Australian Prudential Regulation Authority (APRA)
. Supervision of liquidity and activities of banks of different types and other financial institutions

The Reserve Bank of Australia is:
. Banker to the government, banks and other NBFIs
. Issuer of coins and notes, custodian of overseas reserves
. Promoter of domestic stability (especially the 2-3% price stability target) and external stability using monetary policy

Both link to Banks of different types and other financial institutions.
Banks of different types include:
. Trading/savings banks
. Merchant banks
. Domestic and foreign banks

Other financial institutions include:
. Finance and insurance companies
. Building societies and credit unions
. Superannuation funds
. Managed funds

Question 16

What has happened over the past two decades despite the need for supervision?

Answer 16

Despite a need for some supervision, over the past two decades there has been considerable deregulation of Australia’s financial system.

Question 17

Explain what the deregulation of Australia’s financial system entails.

Answer 17

Deregulation of Australia’s financial system involves removing unnecessary government restrictions on the activities of financial institutions, exposing them to market forces.

Question 18

What are some landmarks in the deregulation of Australia’s financial system?

Answer 18

Early 1980s - Inquiries were conducted. Two important inquiries were conducted into Australia’s financial system that recommended some deregulation of capital markets.

1983 - Deregulation of the exchange rate. This allowed market forces involving buyers and sellers in the foreign exchange market to determine the exchange rate, rather than having it fixed by the RBA.

1985 - Competition from foreign banks. To promote greater competition, improved efficiency and lower interest rates within Australia’s financial sector, the decision was made to allow the entry into the capital market of some foreign banks.

1985 - Replace direct controls on interest rates. Previously, the RBA directly set maximum interest rates that banks could charge. This was gradually replaced by a more deregulated system where interest rates largely reflected conditions of demand and supply in the capital market.

Late 1980s and 1990s - Introduction of prudential supervision. To help create confidence and security in the financial system, banks were originally required to keep adequate cash or liquidity on hand to meet unexpected withdrawals by customers. These liquidity ratios were changed from time to time as a way of regulating bank lending. However, in the mid to late 1980s, these ratios were replaced by prudential supervision of capital adequacy.

Late 1990s - More competition from building societies and other reforms. Some building societies were given licences to operate as banks, thereby further increasing the level of competition and efficiency. The Australian Prudential Regulation Authority took over from the RBA the responsibilities for monitoring the capital adequacy and liquidity situations of financial institutions.

2008-13 - Ensuring stability of the financial sector. Measures were adopted to strengthen liquidity requirements, supervision and other regulations applying to the financial sector in some areas, in the wake of lessons learnt from international banking failures following the global financial crisis and recession.

Question 19

What are the aims/goals of monetary policy?

Answer 19

The Reserve Bank Act of 1959 sets out the functions of the RBA and its board. It seems that RBA’s monetary policy should be used to pursue three key government economic goals related to domestic economic stability. These include:
. low inflation (also called stability of the currency or price stability)
. strong and sustainable economic growth
. and full employment.

Question 20

To achieve its aims what does the RBA do?

Answer 20

To achieve the states aims, the RBA has 3 distinct instruments:

1. Official Cash Rate
2. RBA intervention in the exchange rate known as a “dirty float”
3. Persuasion

Question 21

What has the RBA done since 1993?

Answer 21

Since 1993 the RBA has used a policy of “fight inflation first”. This is known as “inflation targeting”. This is defined as ever age inflation of 2-3% per annum over the business cycle.

Question 22

What happens when the RBA helps achieve the D.E.S. (Domestic Economic Stability) goals?

Answer 22

Through achieving these, the welfare and living standards of Australians should ultimately be improved.

It should also be pointed out that while the RBA’s monetary policy also affects other goals like external stability and equity, these are not usually seen as central to its operations.

Question 23

Explain how monetary policy has been in pursuit of the goal of low inflation.

Answer 23

When inflationary expectations exist and there are signs that inflation will exceed the upper end of the 2–3 per cent target range (and especially when core inflation is up), the RBA will normally tighten its stance (set higher interest rates) in a countercyclical way, to depress inflationary expectations, slow the growth of AD or spending and curb the level of economic activity. Additionally, by slowing AD and economic activity, rises in interest rates help to slow the demand for labour and hence wage pressures, thereby easing cost inflation.

Question 24

What is inflation targeting?

Answer 24

Inflation targeting means that the RBA’s operational goal is to apply monetary policy to achieve an annual average inflation rate of between 2–3 per cent over the duration of the business cycle.

Question 25

Explain how monetary policy has been in pursuit of the goal of strong and sustainable economic growth, and full employment.

Answer 25

Only when the goal of low inflation has actually been achieved will the RBA turn its attention to other aspects of domestic economic stability such as the pursuit of strong and sustainable economic growth, and full employment.

So when the level of economic activity is too weak, yet inflation is under control, the RBA may choose to gradually adopt a countercyclical expansionary stance to stimulate economic activity (without causing an acceleration of inflation).

The main reason for the RBA giving priority to the control of inflation is that low inflation is seen as a precondition for achieving other goals. Limiting inflation is seen as the best way to create conditions that maximise the sustainable rate of economic growth and minimise cyclical unemployment.

The reasoning behind this approach is simple. For instance, low inflation helps to maintain consumer and business confidence that is needed for a steady rise in spending. Low inflation also discourages speculative activity, promotes adequate saving and attracts resources into productive investment in new plant and equipment (as opposed to more speculative uses) that is so important for long-term economic expansion.

Question 26

What is counter cyclical?

Answer 26

Countercyclical application of monetary policy means that during a slowdown, the RBA will cut interest rates to increase AD and lift economic activity, but raise interest rates during an inflationary upturn or boom to slow AD and control inflation.

Question 26

What are the recent aims of monetary policy to 2013 (look at budget and know 2016 instead)?

Answer 26

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Question 27

Explain the nature of pacific monetary policies.

Answer 27

The RBA has three specific instruments of monetary policy that it can draw upon:

1. By far the most important and powerful aspect of monetary policy involves the RBA undertaking “market operations designed to alter the official cash rate and ultimately other interest rates”.
2. A much less important monetary measure entails the “RBA influencing the exchange rate for the Australian dollar through a dirty float” (or changes in
   interest rates).
3. Another option is “RBA persuasion about the desired direction of lending activities of the financial sector”, but this too is much less important as a monetary policy than changing interest rates.,

Question 28

Explain the following instrument of monetary policy: RBA “open market operations” to influence/manipulate interest rates (official cash rate).

Answer 28

All retail banks hold funds in the short-term (overnight) money market. The RBA can manipulate the volume of money in the overnight money market by buying and selling government bonds and securities.

The main determinant of the cash rate (along with other interest rates generally) is the daily conduct of open market operations that directly affect the supply of cash in the short-term money market. Market operations involve the RBA either buying back or selling secondhand government securities or bonds to members of the RITS through the short-term money market.

Question 29

What are bonds?

Answer 29

They are the things the Government gives out in order to finance deficit.

Here, you should think of securities or bonds as simply government IOUs for particular amounts of money that earn a given rate of interest over a period of time.

Question 30

What is the official cash rate?

Answer 30

Official cash rate is the interest rate target set by the RBA for the short-term money market and indicates its monetary policy stance.

Question 31

What is the short-term (overnight) money market?

Answer 31

Short-term money market is a specialist financial institution where credit is borrowed and lent for short periods. In this market, RBA market operations affect the supply of cash and, in so doing, influence the cash rate.

Question 32

What are open market operations?

Answer 32

Open market operations relate to the strategies of the RBA in the short-term money market involving the sale or repurchase of government securities or bonds with the aim of pushing up or lowering the cash rate.

Question 33

What is a monetary policy stance?

Answer 33

Monetary policy stance relates to whether the RBA wants to use interest rates to slow or to accelerate the level of AD and economic activity. A cash rate above 5.5 per cent, for example, is normally regarded as a contractionary stance, but a cash rate below 4.5 per cent is usually seen as an expansionary stance.

Question 34

Explain how the RBA can increase interest rates - a contractionary stance.

Answer 34

If the RBA sells bonds (in exchange for money) to banks who hold exchange settlement accounts (ESA) in the overnight money market (OMM), then the liquidity is reduced in banks. When the volume of cash (supply of cash) is reduced in ESAs then interest rates rise. Meaning the RBA has taken a contractionary monetary policy stance.

This should decrease the amount of “C” and “I” = decreased AD

This often used when the inflation rate rises near or above 3%.

As supply of cash line (inelastic vertical line) decrease it moves down the demand for cash line = higher equilibrium = higher cash rate (vertical axis)

Think: decreased quantity of cash = increased cash rate

Question 35

Explain how the RBA can lower interest rates - an expansionary stance.

Answer 35

If the RBA trades money in exchange for bonds to banks who hold exchange settlement accounts (ESA) in the overnight money market (OMM), then the liquidity is increased in banks. When the volume of cash (supply of cash) is increased in ESAs then interest rates fall. Meaning the RBA has taken an expansionary monetary policy stance.

This should increase the amount of “C” and “I” = increased AD

Lower rates are often announced when AD and economic activity are weak and usually reflect an easier or looser monetary policy stance.

Think: increased quantity of cash = decreased cash rate

Question 36

Explain how the RBA can keep interest rates steady - a neutral stance.

Answer 36

Often, however, the RBA just wants to keep interest rates steady since they are already at an appropriate level, given current economic conditions.

In this case, the RBA’s daily selling and buying back operations will seek to avoid changing the overall supply of cash in the short-term money market, so that the current cash rate remains unchanged.

When the cash rate is held steady at around 4.5% to 5.5%, this is considered to be a fairly neutral stance and within the normal range
for a healthy economy.

Question 37

Explain the following instrument of monetary policy: a “dirty float” by the RBA to affect the exchange rate

Answer 37

As part of its monetary policy, the RBA still retains the option of a dirty floating exchange rate. Dirty floating exchange rate occurs in the foreign exchange market when the RBA becomes a net buyer or net seller of the Australian dollar with the intention of lifting or depressing the exchange rate.

Nowadays it is mainly reserved for special occasions when changes in the dollar are uninformed and erratic, leading to great uncertainty in international transactions. This RBA action can help to smooth out changes in the exchange rate.

Question 38

What is a clean floating exchange rate?

Answer 38

Clean floating (or free floating) exchange rate is a situation where the exchange rate is determined at equilibrium by market forces
of supply and demand for the Australian dollar in the absence of RBA interference in the foreign exchange market.

Question 39

How can the RBA lift the exchange rate?

Answer 39

If the RBA was faced with a situation where the Australian dollar was falling in an erratic and misinformed way, it is likely that it would intervene in the foreign exchange market.

Using a dirty float, the RBA would increase its net purchases of our dollar (reducing net sales of our dollar would have a similar effect) by using its limited foreign exchange reserves made up of other currencies like the euro or US dollar.

Increased demand or buying of the dollar by the RBA will tend to raise our exchange rate (cause an appreciation) because our currency becomes relatively scarcer.

Sometimes this intervention may be all that is needed to smooth the dollar and arrest the fall.

Question 40

How can the RBA lower the exchange rate?

Answer 40

If the RBA was faced with a situation where the Australian dollar was rising in an erratic and misinformed way, it is likely that it would intervene in the foreign exchange market.

This time, instead of buying the dollar, the RBA may intervene in the foreign exchange market by increasing its net sales of our currency (reducing net purchases of the dollar would have a similar effect) to put downward pressure on our exchange rate.

If successful, a weaker dollar would tend to make exports and capital inflow more attractive against imports and capital outflow. This has the potential to increase AD and reduce our current account deficit (CAD).

However, there is the risk that a lower dollar will ignite inflationary pressures, adding to both cost and demand inflation.

Question 41

Summary of the RBA using a “dirty float”.

Answer 41

The RBA decides to smooth out or alter the exchange rate using a ‘dirty float’.

1. The RBA wants to INCREASE THE EXCHANGE RATE or try to prevent a further erratic and/or uninformed fall in the $AUD.
   ⬇️
   Using a “dirty float” in the foreign exchange market, the RBA becomes a NET BUYER (D) of $AUD (D1 to D2), or reduces its net sales of the $AUD causing the dollar to appreciate (ER1 to ER2) - because increased demand moves the equilibrium up the supply line.
   ⬇️
   A STRONGER $AUD than otherwise will tend to increase the CAD, but slow inflation, AD, economic activity and employment.
2. The RBA wants to DECREASE THE EXCHANGE RATE or to prevent further erratic and/or uninformed rises in the $AUD.
   ⬇️
   Using a “dirty float” in the foreign exchange market, the RBA becomes a NET SELLER (S) of $AUD (S1 to S2), or reduce the purchases of the $AUD causing the dollar to depreciate (ER1 to ER2) - because increased supply moves the equilibrium down the demand line.
   ⬇️
   A WEAKER $AUD than otherwise will tend to reduce the CAD, lift AD, economic activity and export incomes, but cause inflation to rise.

Question 42

Explain the following instrument of monetary policy: RBA “persuasion” over the financial sector lending levels

Answer 42

Persuasion is a minor type of monetary policy strategy that may be used by the RBA to talk up or down the level of borrowing, spending and economic activity.

It involves the RBA influencing Aggregate Demand via statements that indicate future movement in the official cash rate.

Eg. Statements by the RBA that future cash rate movements are likely to be increased - will have a contractionary effect as consumers prepare for higher loan repayments. And vice versa

This is where psychology meets economics - interest rates do not need to move at all.

Question 43

What is domestic economic stability?

Answer 43

Domestic economic stability is a desirable or ideal situation for a nation because conditions mean that living standards are most likely to be maximised. Here, domestic stability means that three important government goals are achieved simultaneously, including
1. low inflation
2. strong and sustainable economic growth
3. full employment

Question 44

What is monetary policy usually seen as?

Answer 44

Monetary policy is usually seen as the main stabilising instrument in the short to medium term to help lessen the harshness of inflationary booms and recessions.

It does this mainly by regulating the strength of AD in a countercyclical way using either an expansionary or contractionary stance.

Question 45

What is the RBAs main priority?

Answer 45

RBA is mainly guided by its desire to ‘fight inflation first’ and keep the annual average inflation rate to within its 2–3 per cent target over the duration of the economic cycle.

However, the RBA usually try to achieve the highest rate of economic and employment growth that is sustainable, without causing inflation to accelerate once inflation is sitting in this target zone of 2-3%.

Question 46

How does the RBA decide whether the monetary policy stance should be tighter (contractionary) or looser (expansionary)?

Answer 46

Typically, it uses a checklist of important indicators of the economy’s situation and direction.

1. Trends in inflation
2. Levels of national spending and production
3. Labour market conditions
4. Budgetary policy stance
5. International developments

Question 47

After weighing up often conflicting evidence, what particular monetary policy stance can the RBA adopt?

Answer 47

. Contractionary (tighter to slow AD, economic activity and inflation during an upturn)
. Expansionary (looser to lift AD and economic growth and employment in a downturn)
. Neutral stance (to keep the level of economic activity steady)

Question 47

What are the main indicators of a contractionary monetary policy stance?

Answer 47

1. RBA announces an increase in its cash rate target (above the normal range) in the short-term money market.
2. The RBA proceeds to push up interest rates using its market operations involving net sales of government securities in the short-term money market (at an attractive lower or discounted price).
3. As financial institutions transferred money to the RBA in exchange for the government securities, there was a shortage of cash deposits in their exchange settlement accounts. The shortage of cash in the OMM drives up interest rates.
4. The higher cash rate then spread to other retail interest rates in the financial market via a “ripple effect” (Rates paid on mortgages, credit cards, business overdrafts and savings accounts rise).
5. The higher interest rates then impact on the economy via transmission mechanisms or transmission channels.

Question 48

What is the aim of a contractionary monetary stance?

Answer 48

The aim is to use higher interest rates to reduce inflation to 2–3 per cent per year. This works mainly by slowing AD and economic activity, and through other transmission mechanisms.

Question 50

What are transmission mechanisms?

Answer 50

Transmission mechanisms for monetary policy refer to the ways interest rates effect spending, the Australian dollar and inflationary expectations.

Question 51

What are the three transmission mechanisms?

Answer 51

1. Higher interest rates slow spending
2. Higher interest rates push up the Australian dollar
3. Higher interest rates depress inflationary expectations

Question 52

Explain how the following transmission mechanism works: higher interest rates slow spending

Answer 52

Higher interest rates slow inflation by affecting the decision to save or spend.

Most importantly, higher real interest rates encourage or reward greater saving and they lower credit-sensitive household consumption and business investment spending by making borrowing more expensive.

Both C and I spending are deferred. This slows AD and economic activity, removes shortages of goods and services, and reduces demand inflation.

Question 53

Explain how the following transmission mechanism works: higher interest rates push up the Australian dollar

Answer 53

Higher interest rates tend to slow inflation by pushing up the exchange rate.
Higher domestic rates tend to lift the exchange rate by:
– attracting overseas investment and money capital into the country which lifts the demand for the A$ in
the foreign exchange market, causing a rise in the dollar
– slowing total expenditure and, hence, the spill-over onto imports, thereby reducing the supply of the A$ in
the foreign exchange market
– increasing savings and reducing dependence on overseas borrowing and debt repayments.
In turn, a stronger A$ helps to make imports cheaper, relative to exports. This not only slows AD and demand inflation (by slowing net exports), but it also eases cost inflation pressures.

Question 54

Explain how the following transmission mechanism works: higher interest rates depress inflationary expectations

Answer 54

Higher interest rates can reduce inflationary expectations.
When people get accustomed to inflation and expect it to continue, it becomes a self-fulfilling prediction.

Individuals then take action to protect their purchasing power from the effects of rising prices. Wage earners push for more pay, adding to cost and demand inflation. Asset buyers push up property and share prices, fuelling further inflation.

By contrast, higher interest rates depress inflationary expectations because they affect people’s perceptions and signal the determination of the RBA to control inflation.

Question 55

What are the main indicators of an expansionary monetary policy stance?

Answer 55

1. RBA announces a reduction in its cash rate target (below the normal range) for the short-term money market.
2. The RBA proceeds to bring down interest rates by its market operations involving net repurchases of government securities in the short-term money market. This tends to lift the price of securities, reduce the yield and encourage institutions to get rid of their government securities.
3. As the RBA transfers money to financial institutions (in exchange for their government securities), there is a surplus of cash deposits in exchange settlement accounts. The glut of cash drives down interest rates in the overnight money market.
4. A lower cash rate spread in a ripple effect to other interest rates in the financial market.
5. Finally, a looser monetary policy stance involving reduced interest rates eventually tends to strengthen economic growth and reduce unemployment. At least two important transmission mechanisms operate at this time to help stimulate AD and economic activity.

Question 57

What is the aim of a expansionary monetary stance?

Answer 57

The aim is to use lower interest rates to help lift economic activity and reduce unemployment without increasing the inflation rate. Again this occurs by boosting AD and other transmission mechanisms.

Question 57

What are the main indicators of a neutral monetary policy stance?

Answer 57

RBA sets its cash rate target within the normal range of about 4.5–5.5 per cent for a healthy economy. It then holds interest rates steady by appropriate market operations.

Question 57

What two transmission mechanisms operate to help stimulate AD and economic activity?

Answer 57

1. Lower interest rates lift spending

2. Lower interest rates weaken the Australian dollar ,

Question 57

Explain how the following transmission mechanism works: lower interest rates life spending

Answer 57

Lower interest rates tend to boost economic activity by accelerating AD. This happens because lower rates discourage saving and encourage credit-sensitive C and I spending (that rely on borrowing).

In turn, this tends to cause retail sales to rise and stocks to fall. Firms eventually respond by lifting production (GDP) and employing more resources, including labour. Indeed, the RBA estimates that a real cut in the cash rate of 1 per cent can help to accelerate economic growth in GDP by around 0.8 per cent.

Question 57

Explain how the following transmission mechanism works: lower interest rates weaken the Australian dollar

Answer 57

Cuts in domestic interest rates relative to those overseas initially cause a significant fall in our exchange rate. This is partly because there is more capital outflow from Australia seeking better returns elsewhere.

This leads to increased sales of the Australian dollar in the foreign exchange market, causing the exchange rate to depreciate. In turn, AD should eventually rise due to exports becoming more attractive relative to imports. Again this action is helpful in stimulating economic activity during a downturn and helps to improve domestic economic stability.

Question 59

What is the aim of a neutral monetary stance?

Answer 59

The aim is to neither stimulate nor slow AD and economic activity. Monetary policy is adopting a fairly neutral role.

Question 61

What is macroeconomic policy mix?

Answer 61

Policy mix is the combination of different categories of policy (for example, budgetary policy and monetary policy) to help promote a particular government economic goal, such as low inflation.

This mix can involve compatible relationships or conflicting relationships between the two policies.

Question 62

What is a compatible relationship?

Answer 62

Compatible relationships between policies occur when one policy is complementary or supports another policy
to help achieve a particular government goal.

Question 63

What is a conflicting relationship?

Answer 63

Conflicting relationships between policies occur when one policy undermines or contradicts another policy in pursuing a particular government goal.

Question 64

Some strengths and weakness of monetary policy versus budgetary policy.

Answer 64

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Question 65

Compatibility of monetary policy and budgetary policy.

Answer 65

Current setting for monetary policy is expansionary and historically the lowers official cash rate ever.

Budgetary policy - 2016-17 budget deficit is $37.1 billion which is a slightly smaller deficit than 2015-16 at $39.9 billion. Therefore current budgetary policy stance is slightly contractionary.

On face value these policies appear to not be compatible, however, you could also make a case that given the size of the budget deficit Adam the possibility of an Actual (won’t know actual budget outcome till next year) Budget Outcome which has an increase in the deficit, one could also day both budgetary policy and monetary policy are compatible.

Question 66

What is expansionary monetary policy?

Answer 66

This is when the RBA attempts to expand aggregate demand through cuts to interest rates, the buying back of government securities, or moves to bring about a depreciation of the exchange rate. Such may be appropriate for dealing with severe recessions and unemployment.

Question 67

What is contractionary monetary policy?

Answer 67

This is used to slow or reduce aggregate demand, economic activity and the volume of money. The RBA may attempt this through higher interest rates brought about by increased net sales of government securities and pushing up the exchange rate. Such a policy may be appropriate for dealing with books and rapid demand inflation.