Ch 11 - Monetary Policy

What is monetary policy? (BACKGROUND SO CAN BE BRIEFER)

Monetary policy, similar to fiscal policy, is a demand management or countercyclical policy that is used to influence aggregate demand and therefore, the level of economic activity

Who administers monetary policy? (BACKGROUND SO CAN BE BRIEFER)

The Reserve Bank of Australia (RBA)

How does MP work? (BACKGROUND SO CAN BE BRIEFER)

MP works through financial markets - which are an intermediary between savers (lenders) and investors (borrowers)

What are the 3 main types of financial markets? (BACKGROUND SO CAN BE BRIEFER)

• Loan Markets

• Bond Markets

• Share Markets

Loan Markets (CUT TO SENTENCE OR TWO) (BACKGROUND SO CAN BE BRIEFER)

loan markets – in which business firms borrow money to purchase

assets and capital equipment, and households borrow to fund

their housing mortgage, buy consumer durables and pay for

holidays. Banks, finance companies and credit unions are part of

the loan market

Bond Markets (CUT TO SENTENCE OR TWO) (BACKGROUND SO CAN BE BRIEFER)

bond markets – in which firms and governments sell bonds to

raise finance. A bond is also known as a fixed interest security;

and

Share Markets (CUT TO SENTENCE OR TWO) (BACKGROUND SO CAN BE BRIEFER)

share markets – in which firms obtain finance by issuing new

shares through the stock market.

Why is investment so important? (BACKGROUND SO CAN BE BRIEFER)

Investment is a key ingredient in promoting economic growth and increasing living standards over time. The adage that ‘money makes the world go round’ is very pertinent

What are the 3 key functions of money + explanation (KEEP BRIEF AS IT IS) (BACKGROUND SO CAN BE BRIEFER)

• a means of exchange – money is used for purchasing goods and services;

• a unit of measurement – money measures and compares prices, incomes and asset values; and

• a store of value – money can be saved and used for future transactions.

Why does the RBA pursue price stability (low inflation)? (BRIEFER) (BACKGROUND SO CAN BE BRIEFER)

High inflation erodes the value of money and reduces the ability of money to perform its key functions - thus the RBA pursues the goal of price stability (low inflation) - keeping inflation low to protect the value of money and promote the stability of the financial system.

What is an interest rate (BACKGROUND SO CAN BE BRIEFER)

Interest rates represent the price of money in the savings or loanable funds market

What happens at higher interest rates? (BACKGROUND SO CAN BE BRIEFER)

At higher interest rates, savers will want to supply more funds while borrowers will want to demand less funds (as the cost of borrowing money increases)

What is the difference between nominal and real interest rates? (BACKGROUND SO CAN BE BRIEFER)

The ‘real’ rate is the nominal rate minus the rate of inflation. For example, if the nominal interest rate is 5 per cent and the expected inflation rate is 3 per cent, then the real interest rate is 2 per cent.

The real rate of interest is a measure of how much borrowers actually pay and how much savers receive in terms of purchasing power

What happens to interest rates as inflation rises? (BACKGROUND SO CAN BE BRIEFER)

Whenever inflation rises, nominal rates will also rise by the same margin in order to maintain the same constant real rate.

What is the cash rate (definition)?

The RBA sets an interest rate on overnight loans in the money market. This rate is called the cash rate.

Explain meaning of MP being meant to be “forward looking”?

Monetary policy is meant to be ‘forward looking’. This means that the Reserve Bank’s actions will affect the economy in six to twelve months time. For example, if the Reserve Bank believes that inflationary expectations are beginning to rise, then they will increase interest rates before the inflation rate increases.

What does it mean if the MP stance is to tighten MP?

If the Reserve Bank announces that it intends to raise the cash rate, then the

monetary policy stance is said to ‘tighten’. Monetary policy is said to have adopted a contractionary stance.

What will a ‘contractionary stance’ do to the economy?

An increase in the cash rate will cause contractionary stance in the economy, causing:

• other interest rates to rise - e.g deposit rates, personal and business loans and mortgage rates.

• Both the cost of borrowing and the reward for saving will increase

• Private spending will fall, decreasing aggregate demand.

What does it mean if the MP stance is to ease MP?

If the Reserve Bank announces that it intends to lower the cash rate, then the

monetary policy stance is said to ‘ease’. Monetary policy is said to have adopted an expansionary stance

What will an ‘expansionary stance’ do to the economy

A decrease in the cash rate will cause an expansionary stance in the economy, causing:

• other interest rates to fall, for example, deposit rates, personal and business loans and mortgage rates,

• Both the cost of borrowing and the reward for saving will decrease.

• Private spending will rise, increasing aggregate demand.

What are the 3 economic RBA objectives

• the stability of the currency (low and stable inflation rate)

• the maintenance of full employment (low unemployment) and

• the economic prosperity and welfare of the people of Australia.

Which of these has been elevated to be the overarching objective?

The ‘economic prosperity and welfare of the people of Australia’ - has been elevated to become the overarching objective of monetary policy. Underneath this broad aim, now sit the dual objectives of price stability and full employment.

What does stability of the currency actually mean?

The achievement of a low and stable inflation rate.

What is the RBA formal (since 1983) inflation target?

2-3%

What is meant by the inflation target being “relatively flexible”?

It is also a relatively flexible target as it allows for changes in the business cycle. For example, when the economy is strong, inflation is likely to rise above the target range and when the economy is in a recession, the inflation will fall below the target

What are the benefits of low inflation?

• protecting the value of household savings;

• reducing uncertainty which promotes long term growth and job creation;

• lowering interest rates, creating an incentive for private sector borrowing and spending;

• increasing a country’s international competitiveness;

• encouraging investment in productive assets.

What is the difference between the headline and underlying rate of inflation? 

The CPI

is the ‘headline rate’ that summarises price movements across all classes

of household expenditure and is the measure referred to by the media.

The headline rate, however, can be subject to wide variation and may not

reflect the ‘true’ or ‘core’ rate of inflation. For this reason, the Reserve Bank

monitors a range of measures of underlying inflation since they are more

likely to reflect current inflationary pressures. One measure simply excludes

those items that are relatively volatile due to supply disruptions. Examples

include fruit and vegetable prices which are affected by seasonal conditions,

and petrol prices which are affected by movements in the world oil price.

What are the trimmed mean and weighted median

The trimmed mean is the average rate of inflation after ‘trimming’ away the

items with the largest price changes. The weighted median is the inflation

rate of the item at the middle of the price changes in the CPI basket

How does keeping inflation low (price stability) helps achieve the second objective of full employment?

Keeping inflation low also helps to achieve the second policy objective of full

employment. Low inflation promotes business and consumer confidence and

encourages investment, which underpins employment growth.

How does the RBA define full employment?

The Reserve Bank defines full employment as the maximum level of unemployment that is consistent with maintaining low and stable inflation

What is the NAIRU?

Is there an

estimate for this rate of unemployment? Yes - its called the NAIRU - the non

accelerating inflation rate of unemployment and the Reserve Bank estimates

it to be around 4.5 per cent.

What is the estimated natural rate of UE?

4%

What does economic prosperity refer to?

Economic prosperity refers to rising living standards over time, usually measured as an increase in real GDP per capita.