(ii) Define monetary policy. Discuss the possible channels by which monetary policy might affect the economy?
The Reserve Bank of Australia (RBA) is responsible for formulating and implementing monetary policy. The Board's obligations with respect to monetary policy are laid out in the Reserve Bank Act 1959. Section 10(2) of the Act, which is often referred to as the Bank's 'charter', says:
"It is the duty of the Reserve Bank Board, within the limits of its powers, to
ensure that the monetary and banking policy of the Bank is directed to the
greatest advantage of the people of Australia..” (RBA, 2001-2009)
There are three main objectives of monetary policy, which are to maintain:
- the stability of the currency in Australia
- full employment in Australia
- economic prosperity and welfare of the people in Australia
The RBA board meet every month to determine the monetary policy stance by accounting the development in the domestic and international economies and financial markets. The RBA has a hand on lever approach in setting the cash rate while it watches out for inflationary pressures along the horizon. The cash rate is the rate charged on overnight loans between financial intermediaries to reflect the opportunity cost of holding short-term securities. This can be seen in the upward sloping yield curve.
Changes in the cash rate aims to curb inflationary pressures in the medium-long term and this can be done by using the tools of monetary policy, which influences the supply of ESA funds to ensure that the demand & supply for the ESA funds are kept in balance to meet the required cash rate. Exchange Settlement Accounts(ESA) are accounts kept by banks with the Reserve Bank to settle debts owing to other banks which arise as result of exchange of cheques and to provide funds on which to draw additional notes and coins.
Two main tools to control cash rates are open market operations and Foreign exchange swaps.
- Open market operations:
- The buying and selling of government securities by the RBA in short–term money market.
- When the RBA increases cash rate by selling government securities, the bank’s reserves fall, decreasing credit, decreasing investment, therefore decreasing aggregate demand.
- Conversely, when the RBA decreases cash rate by buying government securities, the bank’s reserves rise, increasing credit, increasing investment, therefore increasing aggregate demand
- Foreign exchange swaps:
- The buying or selling of Australian dollars.
- It is a substitute for open market operations as it works similarly to ESA funds
- Sales of foreign currency to buy Australian dollars will lead to a reduction of ESA funds and purchases of foreign currency will increase ESA funds.
(iii) Consider a situation in which the forecast for the Australian economy over the next two years is for a positive output gap and for rising inflation. The Reserve Bank is considering whether or not to tighten monetary policy.
- Using the aggregate demand and supply model, explain the process of adjustment if the Reserve Bank takes no deliberate policy action.
An increase in the rate of inflation tends to reduce the equilibrium output. A positive output gap, in which short-run equilibrium exceeds potential output, leads to increased inflation, as firms must produce at above normal capacity to meet the demands of their customers Bernanke, Olekalns, Frank 2009, p. 86). They will adjust to this high level of demand by raising prices. If the RBA takes no deliberate action, the economy will go into a state of ‘overheating’ in which spending and output will exceed potential output. (AD-> AD1, AS-> AS1)
AD1
AD AS1
Inflation AS
Output
(b) Suppose the Reserve Bank initially takes no action and inflation rises significantly above its target range of 2-3%. Using the aggregate demand and supply model, explain the process of adjustment if the Reserve Bank responds by tightening monetary policy.
By using tight monetary policy the RBA attempts to reduce total spending by increasing interest rates and encouraging a reduction in the supply of credit.
This aggregate demand/ supply graph shows inflationary pressures (before tight monetary policy is implemented).
There are inflationary pressures of P1 to P2, and the short run equilibrium (QE) output exceeds that of ‘potential’ output (QP).
With reference to the diagrams above – Tight monetary policy works by:
- Announcing the target cash rate from CR1 to CR2 and shifting supply of ESA funds to the left from S1 to S2, decreasing credit availability.
- This affects other interest rates in the money market such as the 3 year fund - increasing interest rates from R1 to R2 decreasing money supplied from SF1 to SF2.
- The rise in interest rate also affects investment demand. As the rise in interest rate from R1 to R2 shifts investment from I1 to I2
- Impacting on the aggregate demand curve to shift to the left from AD1 to AD2.
- However effectiveness of monetary policy depends on the shape of the demand for money curve and shape of the investment demand curve.
Reference List
Bernanke B., Olekalns N., Frank R., 2009, Principles of Macroeconomics: 2nd Edition, Australia, McGraw-Hill Irwin Australia Pty Ltd
Stevens G., Monetary Policy and Inflation: How Does it Work?, Remarks to the Australian Treasury Seminar Series Canberra - 11 March 2008
‘About Monetary Policy’- RBA 2001-2009
