Unit 4, Area of Study 1 - Monetary Policy

Question 1

Objectives of the Reserve Bank as laid out in the Reserve Bank Act 1959

Answer 1

1. Stability of the currency (low inflation or price stability)
2. Maintenance of full employment
3. Economic prosperity and welfare of the Australian people

Question 2

Focus of monetary policy

Answer 2

Stability of the currency and if this is under control they will focus on achieving full employment.

A key understanding here is that the goal of low inflation is the number 1 objective, and only when this is achieved or not a problem will they focus on achieving full employment.

This is outlined in the RBA Charter, which lists the objectives of the RBA

Question 3

Open Market Operations (O.M.O)

Answer 3

It will buy (purchase) and sell bonds / government securities (IOUs)

Or rather the RBA manipulates the supply of cash in the cash market by:

1. Buying and selling Commonwealth Government Securities (CGS), basically bonds
2. or Repurchase Agreements (repos) to participants in the cash market (e.g. banks).

This is referred to as Open Market Operations or Domestic Market Operations.

Question 4

How does the RBA increase the cash rate to place downward pressure on AD?

Answer 4

It will decrease the liquidity (supply) in the overnight money market by selling “bonds” from the bank → the cash flows from the Banks to the RBA via the OMO, taking cash out of the overnight money market → ↓ liquidity (supply) → increases the cash rate → increase cost of borrowing and incentive to save → ↓ C and I → ↓ AD

Question 5

How does the RBA decrease the cash rate to place downward pressure on AD?

Answer 5

It will increase the liquidity (supply) in the overnight money market they will buy or purchase “bonds” from the bank → the cash flows from the RBA to the Banks via the OMO, injecting cash into the overnight money market → ↑ liquidity (supply) → decreases the cash rate → decrease cost of borrowing and incentive to save → ↑ C and I ↑ AD

Remember, to Increase the Supply the RBA Buys (increase, supply, buy)

Question 6

Describing the ACTION of making a change to monetary policy

Answer 6

Tightening Monetary Policy = incresaing the cash rate to place downward economic activity

Loosening Monetary Policy = decreasing the cash rate to place upward pressure on economic activity

Question 7

Monetary Policy Stance or Monetary Policy Settings

Answer 7

Expansionary (can also be described as Accommodative)

Contractionary (can also be described as Restrictive)

Question 8

Rate of Monetary Policy Neutrality

Answer 8

Monetary Policy Neutrality describes a situation where the level of the cash rate is neither working to stimulate nor contract the economy. That is, monetary policy is neither having an expansionary or contractionary effect on the economy.

Currently, monetary policy neutrality involves a target cash rate of approximately 3.5%.

Question 9

The Transmission Mechanism/Channel - 1.Savings and Investment (The cost of credit) channel

Answer 9

Relates to cost of borrowing and incentive to save.

↑ cash rate (and interest rates):

1. C’ers ↑ saving & ↓ spending = ↓ C → ↓AD
2. C’ers & businesses ↓ borrow = ↓ C & ↓ I → ↓AD

↓ cash rate (and interest rates):

1. C’ers ↓ saving & ↑ spending = ↑ C → ↑AD
2. C’ers & businesses ↑ borrow = ↑ C & ↑ I → ↑AD

Question 10

The Transmission mechanism/channel - cash flow channel

Answer 10

Relates to the impact of proportion of income requires to service existing variable rate loans.

↑ cash rate (and interest rates):

1. C’ers with var. rate loan / ↓ proportion of disp. Income avail for spending → ↓C → ↓AD
2. P’ers (bus) with var. rate loan / ↓ proportion of disp. Income avail for spending → ↓I → ↓AD

↓ cash rate (and interest rates):

1. C’ers with var. rate loan / ↑ proportion of disp. Y avail for spending → ↑C → ↑AD
2. P’ers (bus) with var. rate loan / ↑ proportion of disp. Y avail for spending → ↑I → ↑AD

Question 11

The Transmission Mechanism/Channel - Availability of Credit channel

Answer 11

↑ cash rate (and interest rates):

Fewer c’ers and p’er meet criteria for loan → ↓C&I → ↓AD

↓ cash rate (and interest rates):

More c’ers and p’er meet criteria for loan → ↑C&I → ↑AD

Question 12

The Transmission Mechanism/Channel - Exchange Rate Movements channel

Answer 12

Relative interest rates are a factor that will cause the exchange rate to appreciate or depreciation due to capital inflows and capital outflows as domestic and international investors seek the best returns from domestic and international money markets.

↑ cash rate (and interest rates):

= apprec. AUD à ↓ I.C à ↓X & ↑M à ↓AD

↓ cash rate (and interest rates):

= deprec. AUD à ↑I.C à ↑X & ↓M à ↑AD

Question 13

The Transmission Mechanism/Channel - Asset Value/Price channel

Answer 13

↑ cash rate (and interest rates):

= ↓ h/h borrowing → ↓ demand for assets → ↓ asset prices & h/h wealth → ↓ prosperity → ↓C → ↓AD

↓ cash rate (and interest rates):

= ↑ h/h borrowing → ↑ demand for assets → ↑ asset prices & h/h wealth → ↑ prosperity → ↑C → ↑AD

Question 14

Analysing contemporary factors that infleunce the setting of monetary policy

Answer 14

The RBA will consider:

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

Question 15

Why is low inflation the primary goal of low inflation?

Answer 15

Short term:

• Changes to MP (tightening) to lower inflation will lower AD and therefore decrease DD4L ( & growth) à this can attract criticism from some who are focused on the short term, particular politicians à a key reason why RBA legally established as an independent body so it can focus on Australia’s best economic interests.

Medium / Long term:

• Lower inflation has an overall positive effect on jobs and growth. Therefore improving living standards and economic prosperity.
• Becuase consumer purchasing power, consumer and business confidence and international competitiveness are all protected.

Question 16

Strenghts of Monetary Policy

Answer 16

Remember, you must link the strength to the achievement of the goal, or how it enhances the abiltiy to achieve low inflation, full employment and strong and sustainable economic growth.

1. RBA has independence from political bias or considerations, in particular when tightening is required to control inflation.
2. Short implementation lag - Decisions can be made quite quickly as the RBA meets first Tuesday of every month and changes implemented immediately in the overnight money markets = flexibility.
3. Influence on expectations – m.p. is particularly powerful in influencing expectations of economic agents. Concerns expressed by RBA Governor can have powerful influence on consumers, investors, borrowers and lenders.
4. Very effective at controlling inflation – impacts directly on AD via C and I. When inflation is high, tightening of monetary policy reduces borrow, encourages saving à ↓C and ↓I. When inflation is low, loosening monetary policy increases borrowing and discourages savings à ↑C and ↑I. A strength as this supports the achievement of full employment and strong and sustainable economic growth.

Question 17

Weaknesses of Monetary Policy

Answer 17

Remember, you must link the weakness to the achievement of the goal, or how it limits the abiltiy to achieve low inflation, full employment and strong and sustainable economic growth.

1. Imprecise / blunt instrument
2. No direct control over the behaviour of commercial banks
3. Long lag time (recognition and impact) - in 2022 critics would argue the RBA has made this a key weakness as they have been slow to respond to inflationary pressures in the economy.
4. Less effective at stimulating AD during a downturn, due to high levels of debt in Australia and consumers using the opportunity to pay of more of their debt instead of spend on goods and services.
5. MP cannot directly reduce inflationary pressure generated from supply side of economy (cost inflation). A decrease in interest rates to reduce cost inflation will create demand inflationary pressures.

Point 4, is the contemporary to use in a response in the SAC and exam.