Econs- Monetary policy

What is the central bank in Australia and what is its role?

The central bank of Australia is called the Reserve Bank of Australia. The central bank is responsible for the maintenance of overall financial stability and the administration of monetary policy.

What do financial markets do?

They are the intermediary between savers and investors or lenders and borrowers of funds. Financial institutions like banks, building societies, finance and insurance companies, merchant banks and credit unions serve this intermediary role. They are called financial intermediaries because they ‘mediate’ or come between people who have surplus funds and those who want to borrow funds.

Describe the three main types of financial markets

• Loan markets- where business firms borrow money to purchase assets and capital equipment and households borrow to fund their housing mortgage, buy consumer durables (long lasting products that don’t need to repurchased often) and pay for holidays. Banks, finance companies and credit unions are part of the loan market.

• Bond markets- where firms and governments sell bonds to raise finance. A bond is also known as a fixed interest security as bonds are usually sold with a fixed rate of interest to be paid to the lender.

• Share markets- where firms obtain finance by issuing shares through the stock market.

Why is a well-functioning financial sector critical to the economy’s health?

It provides essential financial services to both households and firms. Money and credit facilitates transactions between buyers and sellers, and enable savings to be converted into investment. Investment is a key ingredient in promoting economic growth and increasing living standards over time.

What are the three key functions of money?

• A means of exchange- money is used for purchasing goods and services.

• A unit of measurement- money measures and compares prices, incomes and asset values.

• A store of value- money can be saved and used for future transactions.

Why should the value of money remain relatively stable?

To perform its function money needs to remain relatively stable. High inflation erodes the value of money and reduces the ability of money to perform its key functions. This is why the reserve bank pursues the goal of price stability- keeping inflation low to protect the value of money and promote the stability of the financial system.

Define interest rates and describe who supplies and demands funds.

Interest rates represent the price of money in the savings or loanable funds market. In the market savers supply funds while borrowers demand funds to invest or purchase assets. The equilibrium interest rate settles at a level where the amount people want to lend equals the amount people want to borrow. At higher interest rates, savers will want to supply more funds while borrowers will want to demand less funds. what does the first sentence mean?

Distinguish between real and nominal interest rates and explain why real interest rates are more important to borrowers and lenders.

The nominal interest rate is the interest rate stated by a bank or financial institution, without adjusting for inflation. The real interest rate is the nominal interest rate adjusted for inflation. The real rate of interest is more important to borrowers and lenders because it measures how much borrowers actually pay and how much savers receive in terms of purchasing power. Borrowers prefer low interest rates while savers prefer higher interest rates. Whenever inflation rises, nominal interest rates rise by the same amount so the real interest rate remains constant.

Define monetary policy

Monetary policy refers to the interest rate decisions taken by the Reserve Bank of Australia (RBA) to affect monetary and financial conditions in the economy, with the aim of achieving low inflation and full employment.

Define the cash rate

The cash rate is the interest rate that commercial banks pay to borrow money from each other overnight.

Identify why the cash rate is so important to the RBA.

The cash rate is important to the RBA because its control over the cash rate gives it the power to influence all interest rates across the economy

List areas of the economy that the RBA monitors when implementing monetary policy.

• Rate of inflation

• Wages

• Labour market

• Housing sector

• Business investment

• Exchange rate

• Terms of trade

• National accounts

• International economic data