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Macroeconomics- Demand and Supply of Money, Monetary Policy and Whether the Australian Government should tighten monetary policy.

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Introduction

(i) Discuss the main economic factors that influence the demand for money? The demand for money is the amount of wealth an individual chooses to hold in the form of money. In any household or business the demand for money will depend on a variety of individual circumstances (Bernanke, Olekalns, Frank 2009, p. 86) The demand for money incorporates Transaction Demand which consists of currency (notes and coins) and bank deposits and Asset Demand which compromises financial assets (e.g. Bonds) and is dependent on the level of interest. While businesses and individuals vary considerably in the amount of money they choose to hold, there are 3 main economic factors which influence the demand for money. a) The nominal interest rate (i) The interest rate paid on alternatives to money determines the opportunity cost of holding money. The higher the prevailing nominal interest rate, the greater the opportunity cost of holding money, and hence the less money individuals and businesses will demand. b) The Price level (p) The higher the price of goods and services, the more dollars are needed to make a given set of transactions. ...read more.

Middle

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. 1. 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 2. ...read more.

Conclusion

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: 1. 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. 2. 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. 3. 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 4. 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 ?? ?? ?? ?? ...read more.

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