Monetary Policy Pt.2

Monetary Policy

Management of interest rates by the RBA to influence economic activity.

Cash Rate

The interest rate on overnight loans between banks, set by the RBA each month.

Expansionary Monetary Policy

Decreasing the cash rate to stimulate spending, investment, and economic growth.

Contractionary Monetary Policy

Increasing the cash rate to slow inflation and reduce spending in the economy.

Factors Influencing RBA Decisions

Inflation, economic growth, employment levels, wage growth, and exchange rates.

Price Stability

Maintaining inflation between 2–3% over the business cycle — the RBA’s main goal.

Full Employment

Achieving low cyclical unemployment and operating at the NAIRU (non-accelerating inflation rate of unemployment).

Economic Welfare

Sustaining long-term economic growth and improving living standards.

Policy Interest Rate Corridor

• Roof: 25 basis points above cash rate — RBA lends to banks.

• Floor: 10 basis points below cash rate — RBA pays interest on deposits.

Domestic Market Operations

RBA buys or sells government securities to influence liquidity and the cash rate.

Effect on Interest Rates

↑ Cash rate → banks raise interest rates.
↓ Cash rate → banks lower interest rates.

Transmission Mechanism

Process by which changes in the cash rate affect economic activity through different channels.

Savings and Investment Channel

Higher rates encourage saving and reduce borrowing; lower rates encourage spending and investment.

Cash-Flow Channel

Changes in interest rates alter disposable income for borrowers and savers, affecting spending.

Asset Prices and Wealth Channel

Lower rates increase asset values (e.g., houses, shares), boosting consumer wealth and spending.

Exchange-Rate Channel

Lower interest rates depreciate the AUD, boosting exports; higher rates appreciate the AUD, reducing exports.

Benefits of Monetary Policy

• Short implementation lag (monthly decisions).

• Independent from political influence.

Limitations of Monetary Policy

• Blunt tool (affects all sectors).

• Long impact lag (≈18 months).

• May conflict with fiscal policy.