monetary policies

Monetary policy:

Managed or controlled by Michelle Bullocks change the interest rates depending on the economic conditions.

Interest rates:

-          Reward for saving

-          Cost of borrowing

The RBA is independent of the government

The role of the RBA:

-          Monetary policy

-          Maintain the stability of the financial system

è  Making sure the plumping of the financial system is clear so that money can flow around properly, clear payments, bank for everyone.

-          Issue the nation’s currency

Charter sets out the RBA’s 3 goals:

1.       The stability of the currency (inflation)

2.       The maintenance of full employment

3.       The economic prosperity and welfare of the people (SSEG).

Conventional monetary policy

What they’ve used in the past, they are all about the target cash rate and how they impact interest rates.

-          The RBA can manipulate the rates (cash rate) commercial banks borrow and lend to each other at %.

-          This market is called the overnight money market

-          In theory banks then pass these costs on their customers (via a decrease or increase n interest rates on loans to households and business)

Exchange settlement accounts

-          All commercial/retail banks must hold an account with the RBA.

-          This is used to settle transactions (in batches)

-          ES account must be positive at the end of the day (after all transactions have been settled)

How does the RBA target the cash rate?

-          The RBA intervene in the overnight money market

OMM - This is where banks will borrow or lend to each other in order to settle their ES accounts

-          The RBA intervenes by effectively placing a floor and a ceiling on the interest rates in the market.

The floor – in the market is called the deposit rate

è  Deposit rate is the rate the RBA will pay banks who have surplus $ in their ES accounts

The deposit rate = CRT -0.10% (10 basis points)

(CRT = cash rate target)

The floor – in the market is called the lending rate

è  lending rate is the rate the RBA will change banks who have deficit $ in their ES accounts

The lending rate = CRT + 0.25% (25 basis points)

This to consider on the OMM s/d diagram

-          Supply curve= in vertical (perfectly price inelastic)

-          The deposit rate = the floor of the corridor

-          The lending rate = the ceiling of the corridor

-          Equilibrium price = the market cash rate for borrowing/lending between banks (overnight).

-          The cash rate = the quoted rate form the RBA

-          The actual rate = where the D/S intersect (maybe different to CT)

Changing the cash rate target

-          This is done by simply moving its policy interest rate corridor (up or down).

-          The lending rate = CRT + .25%

-          The deposit rate = CRT - .10%

If the CRT = increases from 3.85% to 4.10% the lending rate and deposit rate (corridor) is adjusted accordingly.

Unconventional monetary policy:

-          Are tools are used by the RBS in conjunction with conventional monetary policy (cash rate targeting) to help achieve their three macroeconomic goals

-          Are tools are mostly used in extremely situations

1.       Asset purchasing (quantitative easing or tightening)

2.       Forward guidance

3.       Yield targeting

Forward guidance:

-          Involves the RBA providing information about the future course of inters rates and its monetary policy

-          settings.

-          The RBA publishes forward guidance through its monetary policy (cash rate) monetary policy statements and other media releases

Time based: would state when the interest rates are rising or decreasing

State based: will not change rates unless they see change in the underlying economy.

The stance of monetary policy:

1.       Expansionary (accommodative/loosening) =

Increase in AD = speedup the economy

è  decrease the cash rate

2.       Contractionary (restrictive/tightening) =

Decrease in AD = slowdown the economy

è  Increase the cash rate

3.       Neutral

When IR is low it increase the demand, when the IR is high it decreases the demand, and in between somewhere would be a point where it is neither expansionary or contractionary.

è  The RBA believes that at this level it will neither encourage or discourage spending/borrowing.

Monetary use conventional and unconventional tools like the CRT and forward guidance that helps with AD.

Neutral rate around 3%

-          Above 3% = contractionary

-          Below 3% = expansionary

-          Move closer to neutral = less

-          Move away from neutral = more

Stance over the past 2 years

Achievement of the macroeconomic goal:

Transmission mechanisms

-          The channels through which monetary policy impact AD

-          There are 4 unique channels or mechanisms you have to learn (there are more)

Savings and investment = ‘cost of credit’

-          Reward for saving and cost of borrowing

-          Impacts decisions to save vs decisions to borrow and spend/invest

-          Affects both households and businesses (C and I)

Cash flow = (for existing debt)

-          Households and businesses who have existing debt

-          Most households have variable interest rates

If the RBA changes interest rates, interest repayments change (debt x interest rate)

-          Affects households discretionary income and businesses cash flow (C and I)

Exchange rate

-          ‘Relative interest rates’

-          Determine where investors will ‘invest’ their money, they find the country with the highest relative interest

-          This will change the demand for AUD (and supply) the exchange rate and therefore (X and M).

Asset prices / ‘wealth effect’

-          Strong evidence to show IRs increase/decrease the price od assets like shares, bonds, property.

-          Low IRs decrease the availability of credit and decreases the risk-free rate (hurdle rate of return) and vice versa

-          This increases demand for assets = increase prices of assets.

-          The ‘wealth effect’ describes the feeling household have knowing the price/value of their assets has changed

-          ‘positive’ or ‘negative’ wealth effect

-          Impacts C and to a lesser extent I

the strengths:

1.       No political bias/constraints

è  The RBA is not elected by the public and has no political affiliation

è  They make decisions purely based one economic factors (not political factors)

è  This gives them the freedom to make economically sound but politically unpopular decisions.

2.       Short implementation lag

è  The RBA meets every month to make a decision about the cash rate target

è  This gives them the flexibility to ‘wait and see’

è  Theu can wait for key economic data before making decisions because they meet every 8 times a year.

3.       No financial constraints

è  Unlike budgetary the RBA does not have financial constraints.

è  It can purchase as many bonds or change the CRT without limitations, as necessary in order to meet the domestic macroeconomic goals.

the weaknesses:

1.       Long impact lag

è  Monetary policy has long and variable lags

è  E.g. = it takes time or changes in the CRT to make its way through the transmission mechanisms and into the economy

Some households have a fixed mortgage rate and will not be effected

Savings buffer

è  Some economist estimate:

o    Only 40% of IR change will be felt after 12 months

o    With 80% felt after two years and

o    100% after 3 years

è  Such a long lag means there is greater chance that monetary policy could become ‘pro cyclical’

2.       Is blunt:

è  Changes in IR by the RBA affect the overall levels of savings, consumption, and net exports.

è  Because the economic impacts of the policy are so widespread, the policy cannot precisely target particular areas of concern.

3.       Creates asset ‘bubbles ‘and high household debt:

è  There is a strong correlation between IR and asset prices.

Prior to this tightening cycle the RBA cut IR over a 10-year period which drove share and house price accumulation

è  Asset ‘bubbles’ can be created in times of expansionary monetary policy (bubbles can burst!!)

Cheaper borrowing leads to more people investing in things like houses, driving up prices. This can create bubbles, where prices are too high. People may also take on more debt. If the bubbles burst, it can cause big financial problems and hurt the economy.