(9) Monetary Policy

Monetary Policy

The actions taken by the Reserve Bank of Australia (RBA) to manage interest rates and the money supply to achieve economic goals.

Goals of the RBA

1. Full employment

2. Stability of the currency

3. Economic prosperity and welfare.

Inflation Target

The RBA aims for 2–3% inflation per year on average over the business cycle.

Money Demand

The amount of money people want to hold for transactions; it decreases as interest rates rise.

Money Supply

The total amount of money available in the economy, controlled by the RBA through open market operations.

Open Market Operations

When the RBA buys or sells government bonds to influence the cash rate and the money supply.

Cash Rate

The interest rate on overnight loans between banks; it is the RBA’s main policy tool.

Expansionary Monetary Policy

When the RBA lowers interest rates to boost consumption, investment, and aggregate demand.

Contractionary Monetary Policy

When the RBA raises interest rates to reduce spending and control inflation.

Transmission Mechanism

The process through which changes in interest rates affect consumption, investment, exchange rates, and aggregate demand.

Recognition Lag

The time it takes for policymakers to notice an economic problem.

Impact Lag

The delay between a policy change and its effect on the economy.

RBA Independence

The ability of the Reserve Bank to set monetary policy without political interference.

Advantages of RBA Independence

Prevents political misuse of monetary policy, maintains low inflation, and builds credibility.

Disadvantages of RBA Independence

RBA is unelected, may prioritize inflation over employment, and lacks direct accountability.

Inflation Targeting

A strategy where the central bank commits to a specific inflation rate (2–3%) to anchor expectations and stabilize the economy.

Effect of Lower Interest Rates

Increases borrowing and spending, boosts AD, GDP, and inflation, and reduces unemployment.

Effect of Higher Interest Rates

Decreases borrowing and spending, reduces AD, GDP, and inflation, and increases unemployment.

Monetary Policy Lags

Policy works slowly because people and businesses take time to respond to interest rate changes.

Money Market

The market where the demand and supply for money determine the short-term interest rate.

Money Demand Curve

Downward-sloping: when interest rates fall, people demand more money.

Shifts in Money Demand

Caused by changes in real GDP or the price level.

Money Supply Curve

Vertical or horizontal depending on how the RBA controls it; determined by policy, not interest rates.

Expansionary Policy Goal

Used during recession to boost AD and employment by cutting rates.

Contractionary Policy Goal

Used during inflation to reduce AD and price pressures by raising rates.

When the RBA lowers the cash rate, what happens to AD?

C) Increases

If the RBA buys government bonds, what happens to interest rates?

B) Fall

The RBA’s inflation target is:

B) 2–3%

Which of the following describes contractionary monetary policy?

B) RBA increases interest rates

Which of the following is NOT a goal of the RBA?

C) Balanced budget