Conventional and unconventional monetary policy

What is conventional monetary policy?

When the Reserve Bank uses the cash rate - it’s primary monetary policy tool - to achieve its economic objectives of price stability and full employment.

How does the RBA changing the cash rate affect the economy?

Interest rates will change as a result which can influence the cost of borrowing and savings which affects business and household decisions to invest and/or consume affecting aggregate demand.

What are examples of areas in the macroeconomy that the RBA affects when they affect aggregate demand?

Real GDP, employment and inflation

How does lowering the cash rate increase inflation?

The economy will be stimulated and economic growth will increase causing an increase in inflationary pressures.

When is the unconventional monetary policy used?

This is used when official interest rates are reduced to zero - referred to as the ‘zero lower bound’.

What happens when the cash rate reaches zero?

The Reserve Bank is unable to stimulate aggregate demand through conventional monetary policy and the cash rate is totally ineffective.

What is unconventional monetary policy?

The use of Reserve Bank policy tools other than the cash rate to affect the level of economic activity.

Either quantitative easing or forward guidance.

What is quantitative easing?

The government purchasing assets, mainly government bonds, in the secondary market.

What are the government bonds in QE?

Commonwealth Government Securities (CGS) which tend to pay a lower rate of interest than corporate bonds because they are guaranteed and therefore risk free.

What is the purpose of QE?

To pump cash into the economy and increase liquidity in hopes that private spending will increase which will increase the level of economic activity.

What is the effect of QE on interest rates and the economy?

Quantitative easing lowers the yield on long-term government bonds (e.g., 5–10 years), which in turn reduces other long-term interest rates such as mortgage rates. This encourages long-term investment and stimulates aggregate demand.

Why does government rates impact other long term rates?

Government bonds act as a benchmark for other long-term interest rates.

What is forward guidance?

Refers to the practice by a central bank of announcing and providing information about its future policy intentions.

What would banks do as a result of forward guidance and how does this benefit business and households?

If the Reserve Bank announces that the cash rate is likely to remain low in the future.

Banks would then set the interest rate for long term loans at a lower level.

This means businesses could get cheaper loans and households would get lower mortgage rates for housing.