G

BUS171 Topic 11

Monetary Policy Overview

Introduction

  • Central aim of macroeconomic policies implemented by government and central banks is to stabilize the economy.

  • Focus on achieving four macroeconomic objectives:

    • Smooth economic fluctuations.

    • Prevent fluctuations from occurring.

Types of Policies

  • Demand Management Policy (Short Run): Addressing demand side of the economy.

  • Supply-Side Policy (Long Run): Focused on enhancing productivity.

Monetary Policy

Definition

  • Actions taken by the Reserve Bank of Australia (RBA) to manage interest rates for macroeconomic objectives.

  • Operates independently from the government.

Goals of Monetary Policy

  • Achieve full employment of the labor force.

  • Maintain low and stable inflation.

  • Promote economic prosperity and welfare for Australians through a healthy growth rate.

Inflation Targeting

  • RBA targets an inflation rate of 2% to 3% on average over the medium term.

  • In the event of economic shocks, the RBA may shift focus towards economic growth and employment.

Impact of Interest Rate Changes

  • Interest rate adjustments affect:

    • Consumer spending (C)

    • Investment (I)

    • Net exports (NX)

  • These components influence growth rate of aggregate demand and economic growth in the short term.

Expansionary Monetary Policy

Purpose

  • Utilized during economic slowdowns or recessions (e.g., GFC 2007-08, COVID-19).

Implementation

  • The RBA decreases interest rates, stimulating:

    • Increased investment (I)

    • Higher consumer spending (C)

    • Positive effects on net exports (NX)

  • Result: Boost in aggregate demand leading to enhanced economic growth.

Contractionary Monetary Policy

Purpose

  • Implemented when inflation rates exceed the target.

Implementation

  • The RBA raises interest rates, resulting in:

    • Decreased investment (I)

    • Lower consumer spending (C)

    • Reduced net exports (NX)

  • Overall effect: Slowing down of aggregate demand and a decrease in upward pressure on prices.

How Monetary Policy Works

Changes in Interest Rates

  1. Open Market Operations (OMOs):

    • RBA buys or sells financial instruments to affect the cash rate.

  2. Cash Rate Definition:

    • The rate charged among financial institutions for overnight loans.

Cash Rate Determination

  • Determined by the interaction of demand and supply for funds in the overnight money market.

  • RBA can alter the cash rate via OMOs by changing cash levels in the market.

Managing Financial Liquidity

Interest Rate Adjustments

  • To lower rates:

    • Announce intentions to reduce the cash rate.

    • Buy bonds which increase money flow into financial institutions.

  • To raise rates:

    • Announce intentions to increase cash rate.

    • Utilize reverse repurchase agreements or sell bonds.

Effectiveness of Monetary Policy

Key Factors Influencing Effectiveness

  • Responsiveness of consumers and firms to interest rate changes.

  • Generally, more effective at reducing aggregate demand than stimulating it.

  • Acknowledge time lags in economic activity (1.5 - 2 years).

Fairness of Monetary Policy

  • Considered a 'blunt instrument'; impacts can vary:

    • Higher interest rates benefit savers but hurt borrowers.

    • Lower interest rates advantage borrowers at the cost of savers (notably retirees).

Summary of Policies

Expansionary Policy

  • RBA decreases cash rate leading to increased spending and investment.

  • Aggregate demand shifts right; higher real GDP and price level.

Contractionary Policy

  • RBA increases cash rate resulting in decreased investment and demand.

  • Aggregate demand shifts right less than it would have without policy, affecting real GDP and the price level.