DM

W6- OB notes Part 3

Definition of Monetary Policy

  • Monetary Policy: Actions taken by the central bank to influence interest rates, aggregate demand, economic activity, and prices.

  • Central Bank: In Australia, the Reserve Bank of Australia (RBA) is responsible for formulating and implementing monetary policy.

Goals of Monetary Policy

  • Vary by country, but Australia targets an average consumer price inflation of 2 to 3% over the medium term, promoting price stability.

  • Low and stable inflation is believed to be linked to higher economic growth and lower unemployment in the long run.

Monetary Policy Transmission Mechanism

  • The central bank influences interest rates that affect aggregate demand, prices, real GDP, and employment levels.

  • Illustration: Expansionary monetary policy lowers interest rates, stimulating spending and investment, while contractionary policy raises rates to cool off an overheating economy.

Effects of Monetary Policy Adjustments

  • Changes in monetary policy can lead to variations in inflation rates, employment, and overall economic output.

  • Example: A reduction in interest rates can increase borrowing and spending by businesses and consumers, leading to economic expansion.

How Monetary Policy Affects Prices, Output, and Employment

  • Detailed exploration reveals the cyclical nature of impacts on prices and employment:

    • Lower interest rates lead to increased investment and consumer spending.

    • Higher output can result in lower unemployment.

Effect of Expansionary Monetary Policy Using AD-AS Model

  • Aggregate Demand-Aggregate Supply (AD-AS) model: Visual representation of how expansionary policies shift aggregate demand rightward, potentially increasing output and reducing unemployment in the short run.

Modern Monetary Policy Implementation in Australia

  • The RBA adopted an inflation target of 2 to 3% in 1996, guiding its monetary policy actions.

  • The RBA maintains the overnight cash rate through mechanisms like open-market operations, influencing broader financial conditions.

Open-Market Operations

  • Mechanisms by which the RBA influences the cash rate and overall monetary conditions, adjusting liquidity in the financial system based on economic signals.

Alternative Views on Monetary Policy Transmission

  • Monetarism: Proposes that changes in money supply directly impact prices, GDP, and employment.

  • Quantitative Easing (QE): Involves central bank purchases of bonds to increase the monetary base when conventional techniques are ineffective (e.g., during a liquidity trap).

The Equation of Exchange

  • Identity: Money Supply (M) x Velocity of Money (V) = Total Spending (PQ)

    • M: money supply

    • V: velocity of money

    • P: price level

    • Q: quantity of output

Quantity Theory of Money

  • Assumes V and Q remain constant, relating inflation directly to changes in the money supply.

Modern Monetarists' Perspective

  • Acknowledge limitations of classic models; recognize that V is not always constant, and economies are not perpetually at full employment.

  • Expect correlation between M and P over the long term, indicating that a sustained increase in money supply leads to deflation.

Monetarism and Monetary Policy Transmission Mechanism

  • Rather than just purchasing interest-bearing securities, excess money holders tend to spend broadly, which more directly impacts economic activity.

Case Study: Monetary Targeting in Australia (1976-85)

  • Money Supply Growth (M3): Targets were set but challenged by the RBA's capacity to control them due to institutional frameworks and conflicts.

Challenges of Monetary Targeting

  • Demand for M3 shifted unpredictably due to financial deregulation and innovations in payment systems, complicating policy implementation.

Interest Rate Dynamics

  • The interaction of money supply and demand determines interest rates, leading to a preference for targeting interest rates over money growth.

Monetary Policy Measures During the COVID-19 Crisis

  • The RBA responded to the crisis by lowering cash rates to unprecedented lows (0.25% and then to 0.1%) and implementing measures aimed at enhancing liquidity and supporting credit flow.

Rules versus Discretion Debate in Monetary Policy

  • Discussions focus on whether monetary policy should be based on strict rules (like targeting money supply) or allow discretion by central banks in response to changing economic conditions.

Countercyclical Macroeconomic Policy

  • Aims to adjust monetary policy to mitigate business cycle fluctuations, ensuring timely interventions to stabilize the economy.

Countercyclical Macroeconomic Fine-Tuning Policy

  • Further exploration of nuanced adjustments in macroeconomic policy to optimize economic conditions.

Delays in Countercyclical Policy Implementation

  • Explains the information, policy determination, and effectiveness lags that can hinder timely manipulation of monetary policy.

Foreign Exchange Market Operations

  • Australia's dollar floated in 1983; RBA may intervene in forex markets exclusively under specific economic conditions to influence market stability.