unit 4 aos 1 monetary policy

Question 1

the need for AD policies

Answer 1

the government & RBA apply budgetary and monetary policy in a countercyclical way to help manipulate the level of AD, helping to increase EA in times of contraction or recession, and slow EA in times of a boom or recovery.

Question 2

monetary policy

Answer 2

aggregate demand strategy that is implemented by the RBA, involving manipulating the actual cash rate of interest, thereby affecting other interest rates and the level of AD
> stabilises economic activity and promotes achievement of domestic macroeconomic goals

Question 3

roles of the RBA

Answer 3

4 main roles under its charter:
- implement monetary policy
- issuing coins and notes
- banker to the federal government (helps finance deficits by issuing bonds)
- acts as a banker to commercial banks

Question 4

role of the RBA in implementing monetary policy

Answer 4

• changes the cash rate and interest rates to influence AD & EA and improve domestic macroeconomic conditions, maintaining economic prosperity and welfare of australians
• they have the responsibility to pursue the domestic macroeconomic goals of low inflation, promoting price stability, strong and sustainable economic growth and full employment, promoting better material WB

Question 5

cash rate target (conventional monetary policy)

Answer 5

cash rate is the interest rate at which banks borrow and lend in the STMM
- the desirable cash rate set by the RBA that changes from time to time in response to economic conditions
> affects longer term interest rates & EA
- the RBA can target the cash rates at which banks borrow from each other in the overnight money market, which banks then pass on to customers through an increase or decrease in interest rate

Question 6

short term money market/ overnight money market

Answer 6

• market set up by the RBA where banks borrow and lend cash to each other for a very short period of time (overnight)
• enables transactions between banks & their customers to be cleared at the end of each day
  > banks can settle their ESA’s at the end of each day

Question 7

exchange settlement account

Answer 7

all banks are required to maintain a positive cash balance at the end of each day in their accounts held with the RBA

Question 8

how does RBA target the cash rate?

Answer 8

intervenes in the overnight money market by placing a floor and ceiling on the cash rate

Question 9

policy interest rate corridor

Answer 9

the range of interest rates operating within the overnight money market within which borrowing & lending by banks must occur
ceiling rate (lending): the rate at which the RBA is willing to lend cash to banks. currently 0.25% above the CRT & floor rate
floor rate (deposit): RBA’s interest paid on excess deposits held by banks in their ESA’s. currently 0.1% below CRT

Question 10

changing the cash rate target

Answer 10

• RBA does this by moving the policy interest rate corridor up or down
• cuts the CRT when AD is too weak, and increases it when AD is too strong
• lending (ceiling) rate = CRT + 0.25%
• deposit (floor) rate = CRT - 0.10%

Question 11

unconventional monetary policy

Answer 11

occurs when tools other than changing interest rates are used to stabilise AD. includes:
- forward guidance (last 2 years)
- asset purchases
- term funding facilities
- adjustments to market operations
- negative interest rates

Question 12

forward guidance

Answer 12

• the RBA’s communication of the future course of its monetary policy stance, it lets people know what the future path of the policy interest rate and other aspects of monetary policy is likely to be
  > provides clarity in times of uncertainty
• can be time based (commits to an interest rate until a certain date)
  or
• based on the state of the economy (commits to a monetary stance until certain economic conditions are met)

Question 13

recent example of forward guidance (unconventional monetary policy)

Answer 13

in 2020, the RBA communicated that it would not increase the CRT until progress was made towards full employment & it was confident that inflation would be within the target 2-3%. it also gave a forecast timeframe of 3 years in which it expected these conditions to be met.

Question 14

transmission mechanisms of monetary policy

Answer 14

the ways in which a decrease or increase in the RBA’s cash rate can be used to bring about a rise or fall in AD & EA to improve domestic economic stability
4 ways interest rates will impact EA:
- by affecting saving & investment (cost of credit)
- by affecting the cashflow of households & firms
- by affecting the asset prices and wealth
- by affecting the exchange rate

Question 15

transmission by changing saving & investment

Answer 15

• most obvious transmission mechanism
• changes in the cash rate and other interest affect peoples decisions about whether to save or invest
  > lower interest rates = cheaper borrowing to finance investment
  > higher interest rates = higher cost of credit = less spending, more saving

Question 16

transmission by affecting cash flow of houses & firms

Answer 16

• interest rates affect the spending of people with existing loans, altering the amount of income they have left to spend on other things
• lower interest rates = more cash to spend on consumption
• higher interest rates = people with loans have to make larger interest repayments & cut other spending

Question 17

transmission by affecting asset prices and wealth

Answer 17

• lower interest rates increase the value of property & shares, as cheaper credit causes a rise in demand
  > asset owners are more likely to increase their consumption spending which stimulates AD
• higher interest rates can cause price of assets to fall, causing owners to decrease spending

Question 18

asset prices/ wealth effect

Answer 18

• describes the feeling households have knowing the value of their assets has changed
• can be positive or negative
• increase in IR = decreased borrowing (availability of credit), lowers demand and price of assets
  > negative wealth effect

Question 19

transmission by affecting the exchange rate

Answer 19

• changes in interest rates alter the attractiveness of investing in aus
• when australian interest rates rise relative to those abroad, capital inflows increase, and outflows decrease, exerting upward pressure on the value of AUD (lowers S and in increases D)
• increase IR = higher AUD = less exports, decreasing AD & inflation, cheaper imports
• cut in IR = lower exchange rate = more exports, increasing AD and EA

Question 20

the stance of monetary policy

Answer 20

the change in the cash rate or policy setting which aims to stabilise the economy
- neutral
- expansionary
- contractionary

Question 21

expansionry monetary stance

Answer 21

• accomodative/ loosening stance to increase AD
• RBA reduces the cash rate target to below ~3.5% to lift AD and stimulate EA
• adopted by the RBA if there is inflation <2%, slow GDP growth, high unemployment, weaker confidence, a slowdown overseas
• aims to stimulate EG and reduce unemployment without adding to inflationary pressures

Question 22

contractionary monetary stance

Answer 22

• tightening stance to decrease AD (slowdown economy)
• RBA increases cash rate to a level above ~3.5% to slow AD and inflation
  adopted if there is high inflation >3%, strong spending & confidence, strong global EG
• slows AD, economic activity and inflation to the target rate

Question 23

neutral monetary stance

Answer 23

• RBA is not trying to accelerate or slow the level of AD & EA
• sets a cash rate target that is consistent with achieving domestic economic stability
• adopted if there is reasonable domestic economic activity with low inflation, SSEG, low unemployment
• around 3.5% interest rate

Question 24

indicator checklist used to guide its monetary policy

Answer 24

1. trends in inflation
2. levels of national spending & confidence
3. labour market conditions
4. budgetary policy stance
   > expansionary budget may cause the RBA to adopt a contractionary stance to avoid inflation pressures
5. international developments
   > slowdown overseas = weaker TOT = expansionary stance to stimulate AD

Question 25

strengths of monetary policy

Answer 25

1. short implementation lags, makes monetary policy flexible
   > change in CRT can be implemented quickly, making it more flexible than discretionary budget
2. monetary policy is most effective in controlling inflation
   > cash rate can be pushed up a long way, which reduces borrowers spending to slow AD
3. monetary policy has no political constraints
   > RBA is independent of gov, which means that it can make economically sound but politically unpopular decision. means that a rise in interest rates are less likely to cause adverse voter reactions than a rise in tax from gov would be
4. RBA media releases can affect peoples expectations & behaviour
   > optimistic statements from the RBA can encourage spending, while more pessimistic statements can be used to dampen EA
5. no financial constraints, can purchase as many bonds as it wants without limitations

Question 26

weaknesses of monetary policy

Answer 26

1. long impact lag
   > limits its usefulness in correcting short term instability, take time to take effect
2. can be a less effective stabiliser in a recession where transmission channels are weaker
3. blunt, unable to precisely target areas of greatest weakness
   > affect overall levels of savings, investment & exports, but cannot precisely target areas of concern because impacts are so widespread
4. may be undermined by budgetary policy
5. can involve goal conflicts & trade offs
6. can cause asset ‘bubbles’
   > expansionaary policy can drive up share and asset aaccumulation & debt

Question 27

stance of monetary policy over the past 2 years & its effect on the achievement of domestic macroeconomic goals

Answer 27

• RBA uses monetary policy to target the goals of low inflation, economic growth and full employment
• 2022 stance: contractionary
• 2023 stance: contractionary
• 2024 stance: contractionary
  > CRT currently at 4.35%, exerting a contractionaery effect on economic activity, with the boards main priority being to return inflation to target 2-3%

Question 28

monetary policy to achieve low inflation

Answer 28

• tightening of monetary policy to above 3.25% to help achieve price stability by:
  1. restricting growth of AD via transmission channels
  2. higher exchange rate will reduce prices of imported goods and decrease pressure on the CPI
  3. tightening policy helps contain inflationary pressures

Question 29

monetary policy to promote SSEG & jobs

Answer 29

• adopts an expansionary policy to stimulate the economy and create jobs when inflation is low
• the growth in AD and EA results in EG and boosts demand for labour
• this is not the current stance, RBA is currently focused on returning inflation to target range

Question 30

monetary policy & exchange rate

Answer 30

RBA buys and sells AUD in exchange for other currency (USD) to manipulate the value of the AUD
> when it buys, it increases in value
> when it sells, it decreases its value