CH11 - Monetary Policy

term 3

What is monetary policy?

Interest rate decisions taken by the RBA to affect monetary and financial conditions in the economy with the aim of achieving low inflation and full employment

What is the main monetary policy tool of the RBA?

The cash rate

What is the cash rate?

The interest rate on overnight loans in the money market

Why can the RBA influence interest rates throughout the economy?

Because changes in the cash rate influence other interest rates (set by Banks etc.) such as mortgage, deposit, personal and business loan rates

What is the real interest rate?

The nominal interest rate minus the rate of inflation

Why are real interest rates important?

They show the real cost to borrowers and the real return to savers in terms of purchasing power

What happens to the cost of borrowing when interest rates rise?

The cost of borrowing increases

What happens to the reward for saving when interest rates rise?

The reward for saving increases

What happens to saving when interest rates rise?

The reward for saving rises, so households have a greater incentive to save

How does a rise in interest rates affect business investment?

Higher borrowing costs make fewer investment projects profitable, so investment falls

What happens to the cost of borrowing when interest rates fall?

The cost of borrowing decreases

What happens to the reward for saving when interest rates fall?

The reward for saving decreases

What happens to saving when interest rates fall?

The reward for saving falls, so households have less incentive to save

How does a fall in interest rates affect business investment?

Lower borrowing costs make more investment projects profitable, so investment rises

What three components of aggregate demand can monetary policy affect?

Consumption, investment and net exports

What is the overarching objective of the RBA?

To promote the economic prosperity and welfare of the people of Australia

What are the two main monetary policy objectives of the RBA?

Price stability and full employment

What does stability of the currency mean?

Price stability or a low and stable inflation rate

What is the RBA inflation target?

An annual inflation rate of 2 to 3 percent on average over time

Why is the inflation target a range?

Because inflation cannot be fine tuned to one exact rate and the target allows for changes in the business cycle

Why is price stability important?

It protects the value of money and supports confidence, investment, growth and employment

What are benefits of low inflation?

It protects savings, reduces uncertainty, lowers interest rates, improves competitiveness and encourages productive investment

What is headline inflation?

The inflation rate measured by the Consumer Price Index

Why can headline inflation be misleading?

It can be affected by large temporary price movements that may not reflect underlying inflationary pressure

What is underlying inflation?

A measure designed to show more persistent inflationary pressures by reducing the effect of volatile price changes

What is the trimmed mean?

The average inflation rate after trimming away items with the largest price changes

What is the weighted median?

The inflation rate of the item in the middle of the distribution of CPI price changes

Which underlying inflation measure does the textbook say the RBA favours?

The trimmed mean

How does the RBA define full employment?

The maximum level of employment that is consistent with maintaining low and stable inflation

What does NAIRU stand for?

Non Accelerating Inflation Rate of Unemployment

What is the textbook estimate of the NAIRU?

Around 4.5 percent

What is the textbook estimate of the natural rate of unemployment?

Around 4 percent

How can low inflation help achieve full employment?

Low inflation supports consumer and business confidence and encourages investment, which promotes employment growth

What does economic prosperity mean?

Rising living standards over time, usually measured by an increase in real GDP per capita

What does the RBA inflation target help anchor?

Inflation expectations

Why are anchored inflation expectations useful?

They reduce uncertainty and support household and business decision making

What is conventional monetary policy?

The RBA using the cash rate to achieve price stability and full employment

What does a tightening of monetary policy mean?

The RBA increases the cash rate

What does an easing of monetary policy mean?

The RBA decreases the cash rate

What is contractionary monetary policy?

A rise in the cash rate that reduces spending and aggregate demand

What is expansionary monetary policy?

A fall in the cash rate that increases spending and aggregate demand

What is a negative output gap?

When real GDP is below potential GDP

What is a positive output gap?

When real GDP is above potential GDP

How can economic indicators identify a weak economy?

Inflation is low, real GDP is below potential GDP and unemployment is high

How can economic indicators identify an overheating economy?

Inflation is high, real GDP is above potential GDP and unemployment is unusually low

When would the RBA usually use expansionary conventional monetary policy?

When economic activity is weak, unemployment is high or inflation is below target

When will the RBA adopt an expansionary stance?

When the economy is weak, there is a negative output gap, unemployment is high or inflation falls below 2 percent

When would the RBA usually use contractionary conventional monetary policy?

When the economy is growing too quickly and inflationary pressures are high

When will the RBA adopt a contractionary stance?

When the economy is overheating, there is a positive output gap, unemployment is very low or inflation rises above 3 percent

What is the likely main RBA priority when unemployment is high and the economy has a negative output gap?

Full employment

What is the likely main RBA priority when inflation is above target and the economy has a positive output gap?

Price stability

An economy has inflation above 3 percent and real GDP above potential GDP. What stance should the RBA adopt and why?

Adopt contractionary monetary policy by increasing the cash rate. Higher interest rates reduce C, I and NX, decreasing AD and real GDP towards potential GDP while reducing inflationary pressure

An economy has high unemployment and real GDP below potential GDP. What stance should the RBA adopt and why?

Adopt expansionary monetary policy by decreasing the cash rate. Lower interest rates increase C, I and NX, increasing AD, real GDP and employment

Why may the RBA raise the cash rate even though unemployment may rise?

If inflation is above target and the economy has a positive output gap, price stability becomes the main priority. Higher rates reduce AD and inflationary pressure but may also reduce employment

What does it mean that monetary policy is forward looking?

The RBA acts according to expected economic conditions because policy changes affect the economy with a time lag

How far ahead does the textbook say monetary policy may affect the economy?

About six to twelve months

What economic indicators does the RBA monitor?

Inflation, wages, labour market conditions, housing, business investment, the exchange rate, terms of trade, national accounts and international data

What is the transmission mechanism?

The process by which changes in interest rates affect economic activity and inflation

Why is the transmission mechanism indirect?

Because the RBA changes interest rates and then relies on households and firms to change their behaviour.

Why are monetary policy time lags uncertain?

Because households and firms may respond differently to interest rate changes over time

What are the four channels of the transmission mechanism?

Cost of borrowing, cash flow, asset prices and exchange rate

Illustrate the full Transmission Mechanism Flow Diagram

What is the interest rate differential?

The difference between Australian interest rates and overseas interest rates

Why does a cash rate rise encourage an appreciation of the Australian dollar?

Higher relative Australian returns attract foreign investment, which increases demand for Australian dollars

How does an appreciation affect net exports?

Exports become more expensive to foreign buyers while imports become cheaper, so net exports decrease

How does the exchange rate channel work when the cash rate falls?

Lower Australian interest rates reduce foreign investment, which decreases demand for the Australian dollar and causes depreciation

Why does a cash rate cut encourage a depreciation of the Australian dollar?

Lower relative Australian returns reduce foreign investment and demand for Australian dollars

How does a depreciation affect net exports?

Exports become more competitive while imports become more expensive, so net exports increase

Explain how a cash rate increase reduces inflation through the transmission mechanism

Higher cash rates raise other interest rates. Borrowing costs and repayments rise, asset prices tend to fall and the AUD tends to appreciate. C, I and NX fall, reducing AD, real GDP and inflationary pressure

Explain how a cash rate cut can reduce unemployment

Lower interest rates increase consumption, investment and net exports. AD and real GDP rise, firms increase production and demand more labour, reducing unemployment

What does the RBA do under expansionary monetary policy?

It decreases the cash rate to reduce interest rates and increase aggregate demand

How does expansionary monetary policy affect household saving?

Lower deposit rates reduce the incentive to save and encourage consumption

How does expansionary monetary policy affect real GDP?

Real GDP increases as aggregate demand rises

How does expansionary monetary policy affect employment?

Employment increases as firms increase production

What happens to unemployment when expansionary monetary policy increases real GDP?

Unemployment tends to fall as firms require fewer workers

How does expansionary monetary policy affect inflation?

Inflationary pressure increases as aggregate demand rises

How does expansionary monetary policy close a negative output gap?

It increases aggregate demand and real GDP towards potential GDP

What does the RBA do under contractionary monetary policy?

It increases the cash rate to increase interest rates and reduce aggregate demand

What is the contractionary monetary policy transmission chain?

Cash rate rises, then interest rates rise, then consumption, investment and net exports fall, then aggregate demand falls

What is the full contractionary monetary policy chain?

Cash rate rises, then other interest rates rise, then C, I and NX fall, then AD falls, then real GDP, employment and inflationary pressure fall

How does contractionary monetary policy affect household saving?

Higher deposit rates encourage greater saving while higher loan repayments reduce consumption

How does contractionary monetary policy affect real GDP?

Real GDP decreases as aggregate demand falls

How does contractionary monetary policy affect employment?

Employment decreases as firms reduce production

What happens to unemployment when contractionary monetary policy reduces real GDP?

Unemployment tends to rise as firms require fewer workers

How does contractionary monetary policy affect inflation?

Inflationary pressure decreases as aggregate demand falls

How does contractionary monetary policy close a positive output gap?

It reduces aggregate demand and real GDP towards potential GDP

What happens to AE under expansionary monetary policy?

The aggregate expenditure line shifts upward

How should expansionary monetary policy be shown in the AE model?

AE shifts upward and equilibrium real GDP rises towards potential GDP

Why does monetary policy have a multiplier effect in the AE model?

An initial change in autonomous spending causes further rounds of income and spending

Why does output rise by more than the initial increase in spending in the AE model?

Because of the positive multiplier effect

How would expansionary monetary policy appear in the AE model?

The AE line shifts upward, causing equilibrium real GDP to rise towards potential GDP through a positive multiplier effect

What happens to AE under contractionary monetary policy?

The aggregate expenditure line shifts downward

How should contractionary monetary policy be shown in the AE model?

AE shifts downward and equilibrium real GDP falls towards potential GDP

How would contractionary monetary policy appear in the AE model?

The AE line shifts downward, causing equilibrium real GDP to fall towards potential GDP through a negative multiplier effect

What happens to AD under expansionary monetary policy?

The aggregate demand curve shifts to the right

How should expansionary monetary policy be shown in the AD AS model?

AD shifts right, causing real GDP and the price level to rise

How would expansionary monetary policy appear in the AD AS model?

AD shifts right while SAS and LAS remain unchanged. Real GDP and the price level rise

What happens to AD under contractionary monetary policy?

The aggregate demand curve shifts to the left

How should contractionary monetary policy be shown in the AD AS model?

AD shifts left, causing real GDP and the price level to fall

How would contractionary monetary policy appear in the AD AS model?

AD shifts left while SAS and LAS remain unchanged. Real GDP and the price level fall