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Monetary policy

This tutorial was written by
Ken Edge
Head Teacher Social Science
Cardiff High School

Outcomes
Overview
Content
Review exercises
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Outcomes

HSC Topic four: Economic Polices and Management is described in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 40 to 42. The specific outcomes from the syllabus for this tutorial are listed below.

A student:

H1 demonstrates understanding of economic terms, concepts and relationships
H2 analyses the economic role of individuals, firms, institutions and governments
H5 discusses alternative policy options for dealing with problems and issues in contemporary and hypothetical contexts
H6 analyses the impact of economic polices in theoretical and contemporary Australian contexts
H7 evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments.

Overview

Monetary policy refers to the actions taken by the Reserve Bank of Australia (RBA) to affect monetary and financial conditions in the money market (also known as the cash market) to help achieve economic objectives of low inflation and sustainable growth.

The Reserve Bank is the Government’s monetary authority and is responsible for formulating and administrating monetary policy. To achieve non-inflationary growth the Reserve Bank sets a targeted “cash rate” (the market rate of interest on overnight funds). For example, the easing in monetary stance during 2001 stimulated aggregate demand and increased economic growth.

However, cash rate increases such as the three 0.25% increases that occurred in May, August and November of 2006, were intended to keep economic growth on target and reduce inflationary pressures. When GDP growth in the economy fell,and unemployment rose because of the international recession the Reserve Bank reduced interest rates in four separate occasions. The following graph shows this course of interest rates.

Graph 4: Interest rates and private demand

(The pink line shows the interest rate. By 2009 the official interest rate in Australia had declined to 3%. This low interest rate was designed to increase growth and investment by lowering he price and cost of borrowing money.)

When a decision is made to change the cash rate the Reserve Bank Board releases a media report (external website) outlining the new cash rate, and the economic reasons for the change.

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Content

  1. The objectives of monetary policy

    In Australia, the objectives of monetary policy are formally established in the Reserve Bank Act. The three main broad objectives are to maintain:

    • inflation at the targeted 2% to 3%
    • full employment at the NAIRU (the non-accelerated inflation rate of unemployment) between 5% and 7%
    • economic growth between 3% and 4% to sustain the living standards and welfare of the people of Australia.

    To achieve these objectives and determine whether there is a need to change “monetary stance” (the loosening or tightening of monetary policy) the Reserve Bank Board meets once a month to review a check list of economic indicators. This check list may include:

    • levels of consumption expenditure
    • indicators of future spending, for example, trends in housing loans
    • surveys of consumer and business confidence
    • trends in employment and unemployment
    • trends in business investment expenditure
    • external sector indicators such as the balance of payments, CAD and fluctuations in the exchange rate.

    The trends in the check list are then used to guide the Reserve Bank decisions on monetary stance.

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  2. Exchange settlement accounts

    Nearly every member of the community has a bank account or an account with a financial institution to conduct their everyday financial transactions.

    Just like the members of the community, the banks need a way to settle transactions that occur on a daily basis.

    To facilitate this process, each of the banks has an account with the Reserve Bank, known as the exchange settlement account (ESA). These accounts are used to settle overnight transactions between the banks and between the banks and Reserve Bank.

    How does an exchange settlement account work?

    Suppose, for example a student has an account with the Swampy Hollow Bank and writes a cheque for $1200 to Fred’s Travel Agency to pay for schoolies week.

    The next day Fred deposits the cheque into his bank. The Swampy Hollow Bank owes Fred’s bank $1200. The Reserve Bank, as the banker to the banks, now credits Fred’s banks exchange settlement account with $1200, and debits the Swampy Hollow’s Banks exchange settlement account with $1200.

    The Reserve Bank requires the banks to keep their exchange settlement accounts in credit. The market rate of interest is paid by the Reserve Bank on these deposits. For example, if the Swampy Hollow Bank doesn’t have enough funds to pay Fred’s bank it needs to borrow the funds from another bank.

    Due to the nature of transactions between the banks and the Reserve Bank there can be a surplus or deficit of cash in the market at any one time.

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  3. What is the cash rate?

    The cash rate is the interest rate that financial institutions pay to borrow or charge to lend funds in the money market on an overnight basis. This measure is also known as the interbank overnight rate.

    Source: Reserve Bank of Australia

    The cash rate is consequently very important, because of its strong relationship to market interest rates. For example, mortgage and business loans rates tend to move in line with movements in the cash rate.

    The Reserve Bank’s influence over the cash rate comes from the changes in the banks demand for exchange settlement funds. For example, payments to the banks by the Reserve Bank add to exchange settlement funds.

    Alternatively, payments by the banks to the Reserve Bank reduce these funds. For example, when individuals and companies make tax payments to the government, cash is drained from the system, and the Reserve Bank has to increase the supply of exchange settlement funds to maintain the cash rate.

    To increase the supply of funds, the Reserve Bank buys securities in the cash market.

  4. Domestic market operations

    Each day in the cash market the Reserve Bank conducts domestic market operations, or open market operations. Open market operations are used to control the daily volume of cash in the market to maintain current interest rates or meet new target rates.

    The Reserve Bank undertakes domestic market operations when buying and selling Commonwealth Government Securities, (CGS) and Repurchase Agreements (usually called “Repos”). Examples of Commonwealth Government Securities are treasury notes and treasury bonds.

    Repurchase Agreements involve the sale or purchase of securities with an undertaking to reverse the transaction at an agreed date in the future and at an agreed price. Repos provide flexibility, in that they allow the RBA to inject liquidity on one day and withdraw it on another with a single transaction. Repos account for about 90% of Reserve Bank’s transactions, averaging about $900 million a day.

  5. Changes in monetary stance

    1. Loosening monetary policy

      To ease monetary stance, the Reserve Bank purchases second hand CGS and Repos from the banks and other financial institutions in the cash market. This leads to an increase in the supply of funds in the market when the Reserve Bank transfers payments to the exchange settlement accounts of the banks.

      The increase in the supply of funds puts downward pressure on both the cash rate and the market rates of interest. For example, a loosening of monetary policy occurred between February 2001 and September 2001 when the cash rate declined from 6.25% to 4.75%. A more extensive loosening occurred in 2008-2009 as the Reserve Bank lowered interest rates to promote economic growth as the international recession started to effect the Australian economy.

    2. Tightening monetary policy

      To tighten in monetary stance, the Reserve Bank will sell new CGS and Repos in the money market. The banks need to withdraw funds from their exchange settlement accounts to pay for these securities. Then individual banks have to borrow funds to maintain their exchange settlement account balances as required by the Reserve Bank.

      A reduction in the supply of cash in the money market raises the cost of borrowing and puts upward pressure on interest rates. For example, the rate increases of 0.25% in May, August and November 2006 were intended to keep economic growth on target and reduce inflationary pressures.

    3. A neutral stance

      This means that the Reserve Bank wants to maintain the current cash position in the market. For example, when an excess demand for cash in the market, puts upward pressure on the cash rate, the Reserve Bank uses domestic market operations to increase supply and stabilise the cash rate. If there is a large surplus of funds the Reserve Bank sells CGS and Repos.

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  6. Monetary policy and the economy (transmission mechanisms)

    When the Reserve Bank changes the cash rate, lending rates of banks adjust quickly. However, it takes longer for individuals and businesses to adjust to these changes.

    The transmission mechanism explains how changes in interest rates are transmitted through the financial system and the economy, and the impact on areas such as inflation and unemployment. The Reserve Bank has grouped these mechanisms under five broad headings.

    1. Savings and investment behaviour

      Higher interest rates discourage borrowing and spending by consumers and encourage savings. Lower interest rates have the reverse effect. The increase in house purchases back in 2001–02 as a result of lower interest rates is a good example.

      The increase in the number of houses built during this period had a flow-on effect to other areas of the economy. For example, the demand for household goods and building materials increased employment, income and spending.

      In the business sector, when the cost of finance is high, less business projects are undertaken. However, the effect on businesses can be difficult to detect, as investment is strongly influenced by the business cycle.

    2. Cash flow

      This relates not to the incentives to spend, but to the amount of cash available for spending. Higher interest rates reduce total household spending, as households typically need more money to pay debts. The effects on business are more dramatic; investment decisions are put off when the cost of servicing debt rises and cash flows decline.

      An interesting point to note is that net interest payments for households are around 3% of aggregate household income and net company interest repayments is about 11% of company operating profits.

    3. Money and credit

      Tightening of monetary policy makes it more difficult for borrowers to obtain loans. As a result, spending is reduced.

    4. Asset prices

      Interest rate changes can affect the value of assets such as houses, property investments and shares. The changes in asset prices in turn affect people’s wealth and spending decisions. For example, higher interest rates typically reduce many asset values such as housing and shares. Reduced borrowing capacity lowers growth in credit and spending.

      However, during the mid to late 1990s the reverse occurred when strong growth in asset prices resulted in high levels of consumption growth and a tightening of monetary policy.

    5. The exchange rate

      Fluctuations in exchange rates affect the price of domestically produced goods relative to imported goods. For example, a depreciation in the value of the Australian dollar relative to other currencies, makes Australian exports cheaper and more attractive to overseas buyers, while imports become relatively more expensive.

      Increasing import prices on consumer and intermediate goods can fuel inflationary pressures in the economy. Expensive imports typically target an increase in the demand for domestically produced import-competing goods.

      Therefore, currency depreciations tend to increase inflation and economic activity while appreciations tend to reduce prices and activity.

      So, the exchange rate becomes a very important channel through which the effects of changes in monetary stance are transmitted in the economy. For example, a rise in domestic interest rates increases the relative return on interest bearing assets to international investors. As the demand for Australian dollars increases, the value of the currency appreciates, reducing inflationary pressures in the economy.

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Review exercises

Exercise 1     Flash version     HTML version

Exercise 2

Use the following sources and the information from the tutorial to answer the following questions that follow below.  Consider also how current economic conditions vary from those outlined below and how the RBA has responded?

Source 1

Media release 2006

STATEMENT BY GLENN STEVENS, RBA GOVERNOR 08/11/06

At its meeting yesterday, the Board decided to increase the cash rate by 25 basis points, to 6.25 per cent. The decision was taken against a background of continued expeansion in the gloabal economy and further evidence that inflationary pressures had increased

 

Source 2 2002

Housing hot, markets not, RBA’s rate rise quandary

Housing borrowing continues to run red-hot, the latest official figures showing property lending growing at more than 19% annually, but the Reserve Bank is still expected to keep its foot off the brake.

The RBA board meets today to consider the latest economic portents and decide whether or not to lift official interest rates.

Source: Harris, S. 2002, “Housing hot, markets not”, The Australian, 1 October,

  1. What is meant by the term “monetary policy”?

    Answer

  2. List the main objectives of monetary policy.

    Answer

  3. Explain what is meant by “monetary stance”.

    Answer

  4. Outline the economic conditions in Australia that caused the RBA to tighten monetary policy in May, August and November 2006.

    Answer

  5. What is the “transmission mechanism”?

    Answer

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More

The Reserve Bank of Australia (external website)web site can be accessed for detailed information on the operation of monetary policy in Australia, media releases and statistics relating to monetary aggregates.

Research activity

  1. Two important systems that allow the Reserve Bank to conduct monetary operations are:
    • Reserve Bank Information and Transfer System (RITS) established in August 1991
    • settlement of debts on Real-Time Gross Settlement (RTGS) System.
    To find out more about RITS and RTGS read the article Implementation of Monetary Policy: Domestic Market Operation (external website) by Frank Campbell.

  2. Monetary policy decisions are expressed in terms of a target for the cash rate. What is the current targeted cash rate (external website)?
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