Unit 6 Flashcards
Define monetary policy
- Monetary policy is a set of actions available to a nation’s central bank to achieve sustainable economic growth by adjusting the money supply
- Cash rate
○ Main tool of Monetary Policy
○ A cash rate is the interest rate that a central bank - such as the Reserve Bank of Australia or Federal reserve - will charge commercial banks for overnight loans
○ The overall aim of Monetary Policy is to contribute to the macroeconomic stability of the economy. Whilst the primary focus is price stability, Monetary Policy is also concerned with economic growth and employment
Explain the role of the RBA
Central banks such as the Reserve Bank of Australia or the Federal Reserve will charge commercial banks interest rates for overnight loans, which is also called cash rate.
State the objectives of the RBA
- The Reserve Bank Board has three objectives when setting monetary policy
○ The stability of the currency of Australia
- This objective is interpreted to mean low and stable inflation
- Inflation is an increase in the general level of prices of the goods and services that households buy
- Low and stable inflation preserves the value, or purchasing power, of money over time
- Australia has a flexible medium-term inflation target, which is to keep consumer price inflation between 2 and 3%, on average, over time
○ The maintenance of full employment in Australia
- This objective relates to the Reserve Bank promoting an environment that supports full employment
- Full employment is where there are enough jobs for people who are available and want to work
- Even at full employment, some people might be unemployed because of skill mismatches or as they move between jobs
○ The economic prosperity and welfare of the people of Australia
- This objective relates to the Reserve Bank promoting an environment that supports the economic prosperity and welfare of the Australian people
- This is primarily achieved by maintaining a stable macroeconomic environment, but it also means the Reserve Bank Board considers other factors, such as financial stability, when setting monetary policy
Explain and describe the transmission mechanism of monetary policy
- The transmission of monetary policy describes how changes made by the Reserve Bank to the cash rate - the ‘instrument’ of monetary policy - flows through economic activity and inflation
- This process is complex and there is a large degree of uncertainty about the timing and the size of the impact on the economy
- Line
□ Cash rate from RBA
® Gives banks credit to loan to businesses
® Business use money to open more businesses, have more staff, which increases spending
□ Interest rates in banks
□ Economic activity in businesses
□ Inflation in consumers - Summary
□ In simple terms, the transmission can be summarised in two stages
® Changes to the cash rate flow through to other interest rates in the economy
◊ Monetary policy in Australia is determined by the Reserve Bank Board and is set in terms of a target for the cash rate
◊ The first stage of transmission is about how changes to the cash rate influence other interest rates in the economy
◊ The cash rate is the market interest rate for overnight loans between financial institutions, and it has strong influence over other interest rates, such as deposit and lending rates for households and businesses
◊ .
◊ While cash rate acts as a benchmark for interest rates in the economy, it is not the only determinant
◊ Other factors, such as conditions in financial markets, changes in competition, and the risk associated with different types of loans, can also impact interest rates
◊ .
◊ As a result, he spread (or difference) between the cash rate and other interest rates vary over time
◊ An example of this has been the increase in banks’ lending rates relative to the cash rate since the financial crisis, which has occurred at the same time as their funding costs have risen
® Changes to these interest rates affect economic activity and inflation through ‘channels’
◊ The second stage of transmission is about how changes to interest rates influence economic activity and inflation
◊ To highlight this, we can use the simple example of how a reduction in interest rates (an ‘easing’ of monetary policy) affects aggregate demand and inflation
◊ A tightening in monetary policy has the opposite effect on demand and inflation
◊ Aggregate demand
} Lower interest rates increase aggregate demand by stimulating spending
} But it can take a while for supply to respond because more workers, equipment and infrastructure may e required
} Because of this, aggregate demand is initially greater than aggregate supply, putting upward pressure on prices
} As businesses increase their prices ore rapidly in response to higher demand, his leads to higher inflation
} .
} There is a lag between changes in monetary policy and its effect on economic activity and inflation because households and businesses take time to adjust their behaviour
} Some estimates suggests that it takes between one to two years for monetary policy to have its maximum effect
Explain and describe the 3 transmission channels
Explain and describe the three transmission channels
® Saving and investment channel
◊ Interest rates influence economic activity by changing the incentives for saving and investment
◊ This channel typically affect consumption (C), housing investment (C), and business investment (i)
} A reduction in deposit rates (interest rates - i/r) reduces the incentives for households to save their money
} Instead, there is an increased incentive for households to spend their money on goods and services
◊ Lower lending rates (i/r) can encourage households to increase their borrowing (lower cost of borrowing) as they face lower repayments and because banks will general lend more to them
◊ Because of this, lower lending rates support higher demand for housing assets
◊ Lower lending rates can increase investment (I) spending by businesses (on capital goods like new equipment or buildings)
◊ This is because returns on these projects are now more likely to higher than the cost of borrowing, helping to justify going ahead with the projects
◊ This will have a more direct effect on businesses that fund their projects with debt rather than those that use shareholders’ funds
® Cash-flow channel
◊ Interest rates influence the decisions of households and businesses by changing the amount of cash they have available to spend on goods and services
◊ This is an important channel for those that are liquidity constrained (for example, those who cannot spend as much as they want because of the size of interest repayments, or because they can’t borrow the amount they want at the current interest rates)
◊ A reduction in lending rates (i/r) reduces interest repayments on debt, increasing the amount of cash available for households and businesses to spend on goods and services
◊ For example, a reduction in interest rates lowers repayments for households with variable-rate mortgages, leaving them with more disposable income
◊ At the same time, a reduction in interest rates reduces the amount of income that households and businesses get from deposits, and some may choose to restrict their spending
◊ These two effects work in opposite directions, but a reduction in interest rates can be expected to increase spending in the Australian economy through this channel (with the first effect larger than the second)
® Asset prices and wealth channel
◊ Asset prices and people’s wealth influence how much they can borrow and how much they can spend in the economy
◊ The asset prices and wealth channel typically affects consumption and investment
◊ Lower interest rates support asset prices (such as housing and equities) by encouraging demand for assets
◊ One reason for this is because the present discounted value for future income is higher when interest rates are lower
◊ Higher asset prices also increases the equity (collateral - assets like property or securities pledged by a borrower to protect the interest of the lender) of an asset that is available for banks to lend against
◊ This can make it easier for households and businesses to borrow
◊ An increase in asset prices increases people’s wealth
◊ This can lead to higher consumption and housing investments as households generally spend some share of any increase of their wealth
