economics SAC monetary policy

definition of monetary policy

is an AD policy, implemented by the RBA, mainly involved to manipulate the actual cash rate, thereby broadly affecting all interest rates and the level of AD 

monetary policy continued

by changing the interest rates in a countercyclical way, the rba can help to stabilise the level of economic activity and improve the achievement of australia’s macroeconomic goals and living standards

monetary policy is an AD policy that operates in a countercyclical way

countercyclical is a policy or indicator that moves opposite to the economic cycle, stabilising fluctuations

conventional monetary policy

involves the rba counter cyclically changing the cash rate in the short term money markets to indirectly after other interest rates and AD

cash rate

is the interest rate that banks pay to borrow funds from other banks in the money market overnight

what is the current cash rate

3.6

target cash rate

is the rba’s announced level of interest rates set for the short term money market. a change in the cash rate is an indicator of the stance for MP

open market operations

involve the rba either selling australian government bonds to the banks or repurchasing them from the banks, allowing the rba to directly change the supply of cash and keep the cash rate on target

why would the government sell government securities

government securities are IOUs where there is a promise to repay borrowed credit at a certain date and rate of interest. 

they are usually sold in australia and overseas to raise finance to cover budget deficits where government outlays exceed receipts

why would a government purchase or buy back CGS?

to manage the national debt, influence interest rates and improve market liquidity.

these actions can help stabilise the economy, manage government finances and potentially lower borrowing costs

CGS meaning

commonwealth government security

MP stance - neutral

describes a situation where the cash rate is neither working to stimulate nor contract the economy. It is not a static figure and is impacted by national and global issues

neutral stance percentage

3.5%

MP stance - expansionary

the target cash rate setting is low enough to be stimulating AD and increasing inflationary pressure. growth is below trend, unemployment is high and inflation below target range

expansionary stance percentage

3.4% or lower

MP stance - contractionary

the target cash rate setting is high enough to be restraining AD and reducing inflationary pressure. growth is above trend, unemployment is low and inflation is above target range

contractionary stance percentage

3.6% or above

loosening of MP

a loosening of MP involves the rba announcing a lower target cash rate in the afternoon of its board meetings

tightening of MP

a tightening of MP involves the rba announcing a higher target cash rate in the afternoon of its board meetings

why would the rba tighten MP?

to control inflation when the economy is growing too quickly. by raising the cash rate, the rba aims to reduce spending, cool down the economy and bring inflation back to its target (2-3%). 

why would the rba loosen MP? 

when the economy is weak or to prevent a recession. by lowering the cash rate, it can stimulate economic activity, boost employment and bring inflation up to its target range if its too low. 

transmission channels

refers to the way in which a change in the cash rate affects other interest rates in the economy and secondly how changes to interest rates affect economic activity

transmission channels purpose

is to explain how the decisions of the RBA affect the real economy. 

they’re pathways that allow the rbas actions to influence economic variables like inflation, employment and economic output. 

what are the 4 channels

cash flow, savings investment, exchange rate and asset wealth channel

cash flow channel

changes in interest rates affect the disposable income of people & businesses with variable rate loans. 

• when rates rise, loan payments increase, reducing the cash they have left to spend or invest. 

• when rates fall, payments decrease, freeing up cash for spending. 

savings investment channel

higher interest makes saving more appealing and borrowing more expensive. this encourages households to save more and discourages businesses from taking out loans for investment, which slows down the economy. 

• lower interest rates do the opposite, encouraging borrowing for consumption and investment. 

exchange rate channel

when interest rates rise, a countries currency becomes more attractive to foreign investors, causing its value to strengthen. a stronger currency makes exports more expensive and imports cheaper, hurting a country's net exports and slowing economic growth. 

• lower rates have the opposite effect, weakening the currency and boosting exports. 

asset wealth channel

shows how changes in interest rates can affect the value of assets like stocks and property. 

• lower interest rates can increase asset prices, making people feel wealthier and more confident to spend. 

• higher interest rates can decrease asset prices, causing a reverse wealth affect where people feel poorer and reduce their spending. 

Unconventional MP

involves the use of measures other than changing interest rates, this may include quantitative easing and term funding facilities. 

it was used by the rba as a special measure during the 2020 recession and the subsequent recovery, to help stimulate AD. 

unconventional MP example

forward guidance

forward guidance

this involves the RBA attempting to provide a degree of certainty about the future direction of interest rates, to make the cash rate more predictable.

distinguish between conventional and unconventional MP

conventional MP involves the RBA countercyclically changing the cash rate in the short term money market to indirectly alter other interest rates and AD. unconventional MP involves the use of measures other than changing interest rates, this may include quantitative easing and term funding facilities. 

• CMP uses interest rate adjustments to influence the economy, while UNCMP employs non-traditional tools like quantitative easing, particularly when interest rates are already near zero. 

• Quantitative easing involves the rba purchasing large quantities of financial assets, like government bonds from the open market to inject a massive amount of money directly into the financial system, lower long term interest rates and encourage banks to lend to stimulate a frozen economy. 

2 strengths of MP

1. MP is very powerful and affects the expectations of economic agents and thus their behaviour. 

2. MP is the main policy used to fine tune AD in an effort to achieve stability in the domestic economy. 

2 weaknesses of MP

1. MP cannot directly reduce inflationary pressures that are generated by supply side issues. 

2. When household debt is high (like it is now), even when interest rates are at an all time low - it doesn't mean people are able and willing to borrow.

evaluate the effectiveness of MP in the achievement of the goal of low inflation over the last 2 years.

over the past 2 years, the rba has been engaged in a significant MP tightening cycle to combat the high inflation that followed covid 19. the effectiveness of this policy has been mixed, demonstrating both clear strengths and weaknesses. 

• S: the tightening of the cash rate has worked to bring AD&S closer to balance, leading to a fall in headline inflation.

• W: the long and variable lag with which MP affects the economy, coupled with an uneven impact on different sectors. 

outline the current monetary policy setting and stance

the current MP stance is at 3.6%, which means it has a slight contractionary impact on the econmy